What is Conduit Theory

Conduit theory is a theory stating that an investment company that passes all capital gains, interest and dividends on to its shareholders shouldn't be taxed at the corporate level like most regular companies. Most mutual funds qualify as a regulated investment company, which gives them conduit status and requires them to be exempt from taxes at the corporate level.

BREAKING DOWN Conduit Theory

Conduit theory can also be known as pipeline theory. The theory is based on the idea that companies passing all capital gains, interest and dividends to their shareholders are considered conduits, or pipelines. Rather than actually producing goods and services in the way that regular corporations do, these companies serve as investment conduits, passing through distributions to the shareholders and holding their investments in a managed fund.

When distributions to shareholders are made, the firm passes untaxed income directly to the investors. Taxes are only paid by the investors who incur income tax on the distributions. Conduit theory suggests that investors in these types of firms should only be taxed once on the same income, unlike in regular companies. Regular companies will see double taxation on both the income of the company and then income on any distributions paid to shareholders, which is an issue of considerable debate. 

Conduit Companies

Most mutual funds are conduits that qualify for tax exemption as regulated investment companies. Other types of companies that may also be considered conduits include limited partnerships, limited liability companies and S-corporations. These companies are exempt from income taxes. Fidelity is one of the largest, most well known S-corporations, filing for the status in 2007. As an S-corporation it is exempt from taxes.

Real estate investment trusts (REITs) also have special provisions that allow them to be taxed as partial conduits. In most cases, real estate investment trusts will be allowed to deduct the dividends they pay to shareholders, reducing their taxes paid through the deduction.

Conduit Mutual Funds

Mutual funds register as regulated investment companies in order to allow for the benefits of tax exemptions. This is an important aspect of consideration for all managed funds that pass through income and dividends to their shareholders. Fund accountants serve as the primary managers of fund tax expenses. Regulated investment companies that are exempt from taxes have the benefit of lower annual operating expenses for their investors. Funds will include details on their tax exempt status in their mutual fund reporting documents.