When, if ever, does it make sense for an entrepreneur to stop taking a salary?

By Reed Richardson

It's a long-held rule of running your own small business: don't forget to pay yourself. However, in an upside-down economy that continually provides exceptions to all the old rules, many entrepreneurs are finding that paying themselves is yet another piece of conventional wisdom worthy of reconsideration. But before you go cold turkey on salary, it's important to ask yourself several questions to make sure you don't unnecessarily risk both your own future as well as your company's.


What are the rules about how much salary a small business owner can/must take?


For most entrepreneurs, there really are no hard and fast legal rules about what they can pay themselves. As a general rule, it's best to pay yourself close to a "market rate" salary for your profession or industry. In fact, a good business plan should already figure in an owner's paycheck as a top-line expense because deferring that salary is, in effect, ignoring a real liability of the company. Still, many sole proprietor and general partnership startups launch with no one on the official payroll and some will end up paying their first few employees a salary before their owners see a substantial return.


Incorporated small businesses, on the other hand, have much clearer rules. Even the founder/owner of a C Corporation is considered a company employee, and so, according to tax laws, he or she must draw a market rate salary. A small business CEO that draws a suspiciously low or zero salary is in danger of arousing interest from the IRS, which might suspect the company of trying to avoid paying its fair share of employment taxes. (Too-high salaries also raise tax alarms, as they could be seen as a way of disguising dividend payments to small business owners.)


Is it really necessary to take $0 as salary?


While salary.com's 2007 Small Business Executive Compensation Index found that the median annual salary for a small business owner was $233,500, most budding entrepreneurs make far less than that. As a result, going "all-in" and accepting no salary to help your struggling startup survive might seem even more necessary, but, by the same token, a consistently lower annual salary also suggests having less money socked away to go income-free for long periods of time.


Instead, small business owners could consider taking a significant pay cut rather than a pay freeze. One tactic might be accepting only enough salary to pay your personal overhead-mortgage/rent, food, car loan, light bill, etc.-and forego any other investing or saving for retirement. This decision particularly makes sense if you're also asking employees to sacrifice a percentage of their salary to buoy your business's chances in tough times. After all, you would never expect them to work everyday for no pay, so to be fair, you shouldn't ask that of yourself either. Also, it's important to recognize the singular role that many small business owners' personal credit score plays in their company's ability to access capital-wreck your own credit rating by skipping a few car payments and, in effect, you've wrecked your company's credit as well.


If I do decide to forego all salary, am I crazy?


Any entrepreneur that foregoes any salary in the early days of his or her company should never feel alone. But in this bleak economic climate, even stable, well-established business owners are joining the club. In fact, a recent American Express Small Business Monitor survey (http://home3.americanexpress.com/corp/pc/2009/mtr.asp) found that 30 percent of small business owners were not currently taking any salary and 27 percent had done the next best thing, by enlisting a family member to work at the business for free. Retail entrepreneurs, in particular, were more than willing to sacrifice a personal paycheck, as more than four in ten-42%-reported taking no salary to help their business survive the recession.


Taking no salary functions like a periodic personal loan you give back to your business. And in an era in which many of the traditional fallback sources of capital for budding entrepreneurs-home equity lines of credit and personal credit cards-have dried up, temporarily recycling all of your salary back into your company offers the advantages of being both simple and immediate. By helping your business's cash flow remain robust enough to meet payroll, keep up with sales demand, and pay vendors in a timely manner, your company will remain attractive to its customers and suppliers, while building solidarity and loyalty among its employees. And by preserving your business's morale, reputation, and credit position, this short-term sacrifice makes your company more attractive to those constituencies that often determine long-term growth and success-lending banks and equity investors.


What are the broader drawbacks and disadvantages to taking a $0 salary?


Make no mistake, if foregoing a paycheck becomes more than a short-term, emergency measure, you are no longer running a business as much as you're running a benevolent employment agency. So, if after several months of no salary your company's fortunes still haven't turned around, that might be a signal that it's time to seriously examine the long-term sustainability of your business. This is particularly true if multiple business partners are subsidizing the company by refusing a salary. In addition, potential capital partners like banks or equity investors will be reluctant to inject any capital in a company that continues to rely upon this cash crutch to survive, even if the money is being plowed back into research and development or expanded production.


From a personal standpoint, taking no salary represents a dangerous, slippery slope for small business owners. For dedicated entrepreneurs, forgoing a paycheck for a few weeks or even a few months can seem like a small price to pay to keep a dream alive. But at some point, reality must set in. Even if your only retirement plan involves selling off your business in forty years, that future sale of your successful business won't put food on the table today. After all, if your company sinks and ends up bankrupt, you can always start another one someday, but that's much harder if your personal fortune goes down with it.