Pipeline Theory

What Is the Pipeline Theory?

The pipeline theory sustains the idea that an investment firm that passes all returns on to clients should not be taxed like regular companies. Capital gains, interest, and dividends as returns are key concepts to understand the pipeline theory. The pipeline theory is also referred to as the conduit theory.

Understanding the Pipeline Theory

If an investment firm passes income directly to the investors, those investors are then taxed as individuals. This means that investors are already taxed once on their income. Taxing the investment company in addition would be akin to taxing the same income twice.

From this perspective, 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. In this way, the primary purpose of these companies is to be a conduit, or a pipeline, for achieving certain tax advantages.

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. This 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.

Types of Pipeline Companies

Mutual Funds

Most mutual funds qualify as regulated investment companies, which gives them pipeline status and requires them to be exempt from taxes at the corporate level. Mutual funds register as regulated investment companies in order to benefit from these tax exemptions. 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.

Other Companies

In addition to mutual funds, other types of companies that may also be considered pipeline companies 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 pipeline companies. In most cases, REITs are allowed to deduct the dividends they pay to shareholders, reducing their taxes paid through the deduction.