This depends on the business structure. In the US, if you have what is called an 'S' corp, then you are required to pay yourself a market rate salary. Otherwise, you are dodging social security, medicare, and other employment taxes. If you have a 'C' corp(as most startups seem to have) then you pay a separate corporate tax so you aren't really dodging taxes. Sole proprietors and LLCs pay "self-employment" tax on pass through earnings, so there is no tax dodging.
S Corp owners are not required to pay themselves market salaries.
What they are required to do is account for their income as if at least a market-salary's worth of it was salary.
You can pay yourself $1/year at an S Corp and be just fine, as long as you don't also issue yourself $200,000 in distributions in that same year and claim to have earned no salary.
This is because (this may set off a little brush fire in the threads, but hey, it beats the silly semantic argument over what the word "profitable" means) S Corps are a giant scam.
For the benefit of the class:
An S Corp, like an LLC, is a pass-through tax entity: the tax liability in an S goes straight to the owners.
LLC owners generally don't make salaries at all. They are paid entirely in distributions (ie, "profit sharing"). LLC owners are subject to self-employment tax on all that income; in fact, an LLC owner must typically pay taxes quarterly, instead of at the end of the year as W2 employees are accustomed. The LLC structure does not (that I know of) afford a huge and obvious opportunity to cheat on your taxes.
Owners of S Corps do take salaries, and do withholding in much the same way as a W2 employee would.
Additionally, as company owners, S Corp owners routinely pay themselves bonuses (profit sharing, distribution, whatever you want to call it). This is normal and reasonable. The business does well, payroll is made, money is reinvested in the company, and what's left over is distributed back to the owners.
The scam is that this money is not for tax purposes treated as payroll. In particular, that money isn't subject to FICA.
As a result, S Corp owners are incentivized to claim the lowest possible salary (today, "lowest" meaning "lowest you could reasonably get away with calling a market salary"). That's because the salary money is going to be subject to FICA. If the remainder of what the owner should fairly have been paid is issued in distributions, that money avoids FICA liability.
And so the IRS case files are littered with lawyers and doctors and dentists who set up their practices as S Corps and then try to claim the fair market rate for their participation in the company is, say, $5,000/year ("oh, I only come in on alternate Tuesdays!"). Their secretaries pay the full bite of FICA while living paycheck to paycheck, while the business owner makes payments on a vacation house with the money they save from this trick.
A relative of mine is an IRS auditor for small businesses. The cheating S Corps, as described by tptacek, take up the majority of his time. I got the same description from him, and he also said doctors were the biggest offenders.
If anyone is doing this, or interested in doing this, the way they deal with these cases is as follows: he picks a number based on a combination of what salary surveys say and what kind of mood he is in, multiplies it by 7 (since you've probably been doing this for 7 years by the time he gets it, which is how far they can go back), and assesses that as unreported income. They then tack on penalties and interest for the tax liability of said income. That makes for a really bad day.
Is that still the case? My understanding is that the PPACA ("Health care reform") does away with most of the tax benefits of sub-s's if they are profitable (i.e. would pay dividends) and so now they are mostly useful as passthrough entities during the loss stage.
It would seem to me that if full payroll taxes are paid on Sub-s dividends, that the requirement there would no longer make any real sense.
It's more complicated than that: it's (iirc; there are actual accountants like 'rprasad who have real answers) a specific new medicare tax on S Corp profits, and active S-Corp owner/employees can avoid it. It's not my understanding that the loophole has been closed entirely.
The point I am clearing up is the issue of "having to pay yourself a market rate salary" which only comes into play if you are making enough to pay anything.
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