What Is an Arm's-Length Transaction?
For the marketplace to work, everyone has to be playing by the same rules. That means, no special deals, both parties are at arm's length. Here's how an arm's length business transaction works.
What Is an Arm's Length Transaction?
An arms-length transaction is a way of looking at transactions between parties who are closely related, either family relationships or business relationships (like a company and a subsidiary). To be a valid transaction, the two related parties must be at arm's length.
An arm's length price takes the personal relationship out of the equation. It's the price that a willing buyer and willing seller would freely agree to if they were not related. Here's a good way to look at what an arm's-length transaction means: In transactions among family members or between business partners should be at Neither party should have an interest in the consequences of the transaction to the other party.
Arms-length and conflict of interest are similar concepts. The question of arms-length transactions usually only comes up in dealings between family members and subsidiaries of a large corporation. But avoiding the appearance of a conflict of interest is relevant for all business transactions.
The opposite of an arms-length transaction is an arm-in-arm transaction, a deal made between two parties who are both interested in the same outcome.
Why Having an Arms-Length Transaction is Important.
Setting a Fair Price. Making sure a transaction is at arm's length is vital in determining the price of some asset (a home or a car or a piece of equipment). The price must be based on the fair market value of an asset, like a building, equipment, or vehicle. The fair market value of a property is the market price, what an informed and unpressured buyer would pay to an informed unpressured seller, based solely on the value of the property.
Buying or Selling a Business. Let's say someone wants to buy a business. Sometimes a business sale the seller has to give a warranty (promise) that all transactions have been arm's length. If the warranty is incorrect (there is a non-arms-length transaction, the other party could be entitled to damages.
A warranty in a contract is an expressed or implied undertaking that a certain fact regarding the subject matter of a contract is, or will be, true. In this case, the warranty would state that all transactions are at an arm's length basis.
Avoiding Tax Consequences. If a transaction is not arm's length, it can be questionable from a tax standpoint. For example, a non-arms-length transfer of assets between subsidiaries may result in a price that is too high or too low, which can affect taxable income for the parties. If the IRS audits the companies and finds that the transaction doesn't meet arms-length status, it could result in penalties.
If the IRS considers the transaction to be "controlled" and not arm's length, it might calculate the taxes as if the transaction were neutral (at arm's length).
Avoiding Conflict of Interest. An arm's-length transaction can be used to avoid the appearance of a conflict of interest or to keep the relationship "business-like" so the personal relationship is not affected. If a conflict of interest is discovered, it can void a contract.
Arm's-Length Transactions in Real Estate
In these tough real estate buying and selling times, real estate purchases have been more closely scrutinized. An arm's-length transaction is required in real estate deals to assure that the property is being sold at fair market value, not at some artificially low price.
In fact, Fannie Mae requires an affidavit of the arm's-length transaction in short sales, to prevent family members or co-business owners from making special deals. The affidavit requires the parties to confirm that there are no hidden terms or special understandings in the sale and that there are no family, marriage, or commercial connections between the buyer and seller.
Is an Arm's-Length Transaction Really Possible in a Family Business?
Tim and his father Karl had an arm's-length relationship when they worked in the family business that they jointly owned. They never talked about business at home and they treated each other at work as colleagues rather than father and son.
Does that sound realistic? Maybe. Maybe not. Running a family business brings a whole new set of problems, made more complicated by the close relationships between the parties: owners and employees. But there are ways to make sure a contract is negotiated at arm's length.
How to Make Sure You Have an Arm's-Length Transaction
If a contract "goes bad," and one party decides to sue, and there is a question about whether the contract is arm's-length, things can get ugly. Or, if the transaction might come under IRS scrutiny, you should have documentation that the transaction is at arm's length. You want to avoid even the appearance that there is a conflict of interest.
Some suggestions for making sure that business transaction is arm's-length:
- Get an independent appraisal. If you are buying or selling a property, get a real estate appraisal. If you are buying or selling a business, get a business valuation. Then stick to it.
- Get independent negotiators. Get an attorney or broker for both parties and let the attorneys do most of the negotiating.
- Get it in writing. Put the contract in writing. No handshake or verbal contracts. Make sure that every element of the deal is spelled out. There should be no hidden clauses or verbal understandings.
The best way to make sure your business transactions and contracts are arm's length is to have these transactions prepared by an attorney. Check with your attorney before you enter into an agreement with a family member or between subsidiaries in a business.
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Nasdaq. "Arm's Length Price." Accessed Dec. 6, 2019.
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We Agree. "(e) An arm's length away." Accessed Dec. 6, 2019.
Accounting Tools. "Arm's length transaction." Accessed Dec. 6, 2019.
IRS. "Arm's Length Standard." Accessed Dec. 6, 2019.
Supreme Court of California. "Thomson v. Call (1985)." Accessed Dec. 6, 2019.
Fanniemae.com "Short Sale Affidavit (Form)." (Download) Accessed Dec. 6, 2019.