Does the IRS Really Hate Captives? Breaking Down 831(b) & Micro-Captives

Let’s be real: if your client brings up 831(b) or micro-captives, they’re probably doing it with one eyebrow raised. Captives have earned a reputation—fair or not—of being risky territory when it comes to the IRS.

The truth? Captive insurance is a 50+ year-old, IRS-recognized model used by thousands of businesses to insure their risks legitimately. But like any tool, it can be abused. And when bad promoters push tax-first strategies, the IRS takes notice and tightens the screws for everyone.

Captives aren’t scams. But they do require discipline, documentation, and clear non-tax business purposes.

This article breaks down:

• Why the IRS is watching captives closely
  
  
• What 831(b) and micro-captives actually are
  
  
• What makes a captive compliant vs. a red flag
  
  
• How to keep your client’s captive above reproach

Why Is the IRS Watching Captives So Closely?

Your clients may have heard about tax advantages with captives. And yes, certain tax elections (like 831(b)) can allow captives to pay tax only on investment income.

But here’s what they need to understand:

If tax benefit is the only reason they’re forming a captive, they’re asking for trouble. The IRS will be their “best friend” in the worst way. 

The IRS has seen too many business owners enter captives without proper underwriting, risk management, or legitimate insurance needs.

And when that happens, it puts a spotlight on everyone.

That’s why it’s critical to emphasize this with your clients:

A captive should be built first as an insurance company. Captives are a long-term financial and insurance strategy. NOT a tax strategy.

If your client can’t support their premiums with actuarial data or doesn’t have a real insurance need, they’re creating a target.

How Captive Deductions Work and Why the IRS Cares

Here’s the key difference to explain to clients:

• When they buy insurance from a third-party carrier, premiums are deductible, but only after they’re paid.
  
  
• If they set aside money in a rainy-day fund instead, they get no deduction until actual claims are paid.

But when they form a captive insurance company, that captive can deduct anticipated future losses. Just like a traditional insurer.

That’s where the tax benefit comes in. But that’s also why the IRS wants to know:

“Is this a real insurance operation or just a tax play in disguise?”

Make sure your clients know:

• Captives can offer real tax advantages, but only if they’re formed for legitimate risk management purposes.
  
  
• If their primary motive is the write-off, they’re already in the danger zone.

What the IRS Looks for When Reviewing a Captive

If your client ever ends up under IRS scrutiny, here’s what will be on the checklist. Every legitimate captive must demonstrate:

1. Insurance Risk
   
   • There must be a real possibility of loss (not speculative or contrived).

1. • That risk must be distinct from business or investment risk.

1. • The captive must actually operate like an insurance company. Formally, independently, and at arm’s length.
     
     
2. Common Notions of Insurance
   
   • The coverages must align with what insurance normally protects: physical damage, liability, etc.
     
     
   • If the policies seem obscure or far-fetched (e.g., hurricane insurance in a non-hurricane zone), the IRS will push back. And they’ll push back hard.
     
     
3. Risk Shifting
   
   • The captive must truly take on the risk. No guarantees, no funny business.
     
     
   • If the insured still shoulders the burden of a loss, it’s not insurance—it’s a sham.
     
     
4. Risk Distribution
   
   • There must be a broad enough spread of risk. This is either across multiple entities, locations, or exposures.
     
     
   • One business covering only itself doesn’t meet the threshold.

Make sure your clients know:

A captive isn’t legitimate just because it’s registered. It’s legitimate when it walks, talks, and performs like a real insurance company.

What Are Micro-Captives and 831(b)?

Some of your clients might ask about 831(b) captives, also commonly known as micro-captives. These are small insurance companies that elect special tax treatment under Section 831(b) of the IRS Code.

Here’s what that means:

• They pay tax only on investment income, not on underwriting profit
  
  
• Annual premium limits apply (indexed annually—currently in the low $2M range)
  
  
• They must elect 831(b) treatment, and they can’t be life insurers

Originally designed for small, often rural mutual insurers, 831(b) has become a lightning rod for abuse. Why?

Because bad actors have:

• Pitched it as a tax shelter without proper risk
  
  
• Created fake policies for low-probability events
  
  
• Failed to follow actual insurance operations

The result? The IRS now considers 831(b) captives a “transaction of interest,” meaning extra documentation and heavy scrutiny apply.

Your role is to make sure your clients understand:

Micro-captives can be legitimate, but the bar is much higher, and mistakes are costly.

How to Help Your Clients Avoid IRS Trouble

Let’s be blunt: The IRS doesn’t hate captives. It hates bad captives.

Here’s how your clients stay on the right side of the line:

• Have a non-tax business reason
  If they’re only joining for a deduction, that’s a red flag. Risk management, cost control, and claims transparency are the core drivers.
  
  
• Back up every premium with actuarial data
  Pricing must be supported by third-party actuaries. Not back-of-napkin math or wishful thinking.
  
  
• Avoid ridiculous coverages
  Earthquake coverage in Michigan? Hurricane insurance in San Diego? If it’s obviously artificial, the IRS will see right through it.
  
  
• Document everything
  Formation rationale, claims protocols, governance structure, financial oversight. All of it needs to be airtight.
  
  
• Work with licensed, experienced professionals
  If the promoter doesn’t hold an insurance license or talks only about tax savings, your client needs to run. Read our article on whom to avoid about captives and who you should be talking to about the subject.

Remind them:

A captive is a real insurance company. It needs to look, act, and operate like one.

Next, you should read about offshore captives. That way, you can see what the IRS thinks of offshore captives.

Want to learn more about how captives work? Join Captive Coalition for FREE. You’ll get access to tools, resources, and training built to help independent agents serve their clients better and protect your book of business.