Managing risk and insurance is already complicated for your clients, especially when rising costs keep cutting into their margins. Naturally, some will start exploring alternative financial strategies, including captives.
But let’s be clear: if your client is looking at a captive as a tax shelter, they’re setting themselves up for trouble.
Captives are not a tax play. If your client is in it for the tax perks, not the risk management, they’re inviting the IRS into their business. And most business owners sure don’t want that happening.
At Captive Coalition, our sole mission is to educate independent agents like you so you can retain your best clients with captive insurance done right. We’ve interacted with agents whose clients join captives for the right reasons. And we’ve turned away agents whose clients wanted to use captives as a tax shelter.
In this article, you’ll get the real story on why captives aren’t tax shelters, what the IRS looks for, and how to guide your clients toward the right mindset: captives as a long-term risk management tool. Not a tax loophole.
How Does Captive Insurance Work?
Before you can help your clients avoid the wrong mindset, make sure they understand what a captive actually is.
A captive insurance company is an insurance entity owned and controlled by the insureds. It’s created to cover their own business risks. Just like any other insurer, a captive must follow strict regulatory requirements in its jurisdiction, whether it’s onshore or offshore.
There are multiple structures your clients might enter:
- Single-Parent Captive: One business owns and operates it to insure only its own risk.
- Group Captive: Unrelated businesses join together to share risk and insurance costs.
- Cell Captive: Multiple entities operate in separate “cells” within a shared structure, allowing risk separation while sharing administrative infrastructure.
Captives are, first and foremost, an insurance and long-term financial strategy. If your client is looking at it through the lens of tax reduction, they’ve already missed the point. And that’s where trouble starts.
Why Some Clients View Captive Insurance as a Tax Shelter
Some business owners get lured by the idea that captives offer tax advantages. They hear they can deduct insurance premiums and defer taxes on the captive’s income. On the surface, it sounds like a clever financial move.
But as their agent, you need to redirect that thinking. And address it fast.
Captives do come with real benefits: improved risk management, better cost control, and long-term financial stability. But the IRS is laser-focused on sniffing out captives that exist purely for tax avoidance, especially if they see one take an 831(b) tax election.
If your client is asking about the “tax play,” that’s your red flag to refocus the conversation. Or even suggest they don’t use captives. Captives are a risk management tool first. If the IRS sees them used otherwise, they’ll come in hard.
What Are the IRS Risks If a Captive Is Misused?
The IRS doesn’t mess around when it comes to captives. If your client’s captive isn’t structured as a legitimate insurance company, they’re opening the door to audits, penalties, and back taxes.
To be recognized as a bona fide insurer, the captive must meet three basic standards:
- Risk Transfer: The captive must actually assume risk from its insureds.
- Risk Distribution: That risk must be spread across unrelated entities. Not just one business with shell subsidiaries.
- Insurance Characteristics: The coverage must be for real, insurable risks. They can’t be exaggerated or fabricated scenarios.
If those boxes aren’t checked, the IRS can—and will—disallow deductions. In some cases, they’ve gone after captives like a bloodhound, especially those under the 831(b) tax election.
Clients who set up captives purely for tax benefits or use wildly inflated premiums on far-fetched risks (like hurricane insurance in landlocked states) have faced serious legal consequences. When the IRS comes calling, they don’t show up empty-handed. They bring penalties (and pain). Don’t let them walk into that trap.
Common Misconceptions About Captives and Taxes
One of the biggest myths your clients may believe is that a captive can be used to stash cash and avoid taxes. That’s false.
Even if the captive is set up correctly, distributions are still taxable. And the administrative costs—actuarial services, audits, regulatory compliance—can quickly outweigh any perceived tax advantage.
If your client thinks captives are a clever tax workaround, they’re putting themselves at financial and legal risk. Help them understand that captives are an investment in risk control, not a shortcut to tax savings. Not unless they want to be best frienemies with the IRS.
How Your Clients Should Use Captive Insurance
If a client says they’re looking at captives for tax purposes, stop them right there.
Captives are an insurance strategy. They’re designed for businesses that prioritize safety, risk management, and control over their insurance outcomes.
A properly structured captive lets your client self-insure specific risks that may not be covered well in the traditional market. And when claims stay low, the long-term financial benefits are real: reduced premiums, underwriting profit, and greater control over their insurance spend.
Clients sometimes need to be guided toward that mindset: risk management first, financial benefit second. If they’re only in it for a tax play, they’re not a fit.
Captives Are a Long-Term Insurance Strategy. Not a Tax Move.
Using a captive as a tax shelter will backfire. It’s a bad strategy and a risky move that invites audits, fines, and a damaged reputation.
But when your client approaches captives with the right intent—controlling risk, lowering long-term costs, and building financial stability—they can see real benefits. You can help them stay focused on what captives are actually for.
If your client is serious about risk management and ready to think long-term, then a captive might be the right move.
Want to dig deeper? Read “Identifying Your Best Clients for a Captive Insurer” or check out “How Does My Client Profit in a Captive?” to better guide your next conversation.
Want to learn more about captive insurance? Become a member of Captive Coalition for FREE to access additional tools, resources, webinars, and training to help your best clients and maintain your book of business.
