What is an Arms-Length Transaction?

How to Pass the Arms Length Test for a Business Transaction

Arms-length Transaction Definition
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For the marketplace to work, everyone has to be playing by the same rules. That means, no special deals. A business contract for the sale of something is assumed to be "willing buyer and willing seller," which means no pressure based on the relationship. The concept that rules is called the "arms-length transaction."

What is an Arms Length Transaction?

An arms-length transaction is a transaction between two parties who have a personal or family relationship. The transaction is kept separate (at arms-length) from their personal relationship. An arms-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.

Here's a good way to look at what an arms-length transaction means: Neither party should have an interest in the consequences of the transaction to the other party. The opposite of an arms-length transaction is called an arm-in-arm transaction. Nice phrase. It illustrates the issue - if the parties are arm-in-arm, the transaction is unbalanced because they are working together to benefit one party. 

Arms-Length Transactions in Real Estate

In these tough real estate buying and selling times, real estate purchases have been more closely scrutinized. An arms-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 arms-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.  Any violation of this affidavit is considered as mortgage fraud. 

Arms-Length Transactions and Taxes

Another example of how a transaction between family or friends might be difficult is in the area of taxes. A real estate transaction between a mother and son, for example, might be considered by the IRS not to be arms length unless the parties can prove otherwise. If the IRS considers the transaction to be "controlled" and not arms length, it might calculate the taxes as if the transaction were neutral (at arms length). 

Is an Arms-length Transaction Really Possible in a Family Business? 

Tim and his father Karl had an arms-length relationship when they worked in the family business that they jointly owned. They never talked 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 Arms-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 arms-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.