DEFINITION of Pipeline Theory

Pipeline theory is the idea that an investment firm that passes all returns on to clients should not be taxed like regular companies. Pipeline theory includes capital gains, interest and dividends as returns that should be considered. Also referred to as "conduit theory."

BREAKING DOWN Pipeline Theory

Most mutual funds qualify as a regulated investment company, which gives them pipeline status and requires them to be exempt from taxes at the corporate level

According to pipeline theory, the investment firm passes income directly to the investors, who are then taxed as individuals. This means that investors are already taxed once on the income. Taxing the investment company is addition would be akin to taxing the same income twice.

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.

Pipeline Companies

Most mutual funds are pipelines 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.

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

Pipeline Mutual Funds

Mutual funds register as regulated investment companies in order to benefit from 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.