What Is an Arm's Length Transaction?
Definition & Examples of Arm's Length Transactions
An arm's length transaction is one in which both parties are acting in their own best interest. That means they have negotiated fairly on price, and neither party is giving the other one a deal better or worse than the market would dictate because of an existing relationship between them.
Learn more about arm's length transactions and how to make sure you are carrying one out if you need to.
What Is an Arm's Length Transaction?
An arm's length transaction is one that takes place as if the two parties involved had no pre-existing relationship. If two people are at arm's length from each other, they aren't too close for the sake of a fair deal that is priced in line with market expectations.
Parties that have an existing relationship—like parents and their daughter or a company and its subsidiary—might be inclined to negotiate a deal that's more favorable to the party with less money. Or the more powerful party might try to strong-arm the other into accepting a less-than-fair deal. Or the parties might act in concert to manipulate the price for tax purposes.
None of those scenarios is allowed to happen in an arm's length transaction.
How Does an Arm's Length Transaction Work?
An arm's length price is a price that a willing buyer and a willing seller would reasonably agree to if the buyer were trying to get the lowest price possible and the seller were trying to get the highest price possible. It's also important for an arm's length transaction that there be no undue pressure on any of the parties and that both parties have all of the same necessary information.
There are steps you can take to reduce the impact an existing relationship can have on a deal.
- 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. The agreed-upon price should be close to the figure arrived at by the independent evaluator.
- Get independent negotiators. Both parties should hire an attorney, broker, or some other type of independent professional intermediary. Those people should do the negotiating, and you and the other party should stay out of it.
- Get it in writing. Put the contract in writing, without exception. Make sure that every element of the deal is spelled out.
Alternatives to an Arm's Length Transaction
The opposite of an arm's length transaction is an arm-in-arm transaction, a deal made between two parties who are both interested in the same outcome.
Arm-in-arm transactions aren't necessarily illegal, but they may run afoul of the IRS or prevent you from obtaining financing from a lender.
In some transactions, such as the sale of a business, the seller has to give a warranty that all aspects of the transaction have been conducted at arm's length. If that was not the case, the buyer could be entitled to damages.
If a transaction is not carried out at arm's length, it can cause difficulties from a tax standpoint. For example, the IRS could determine that the amount below fair value at which you sold your house to your son and daughter-in-law was a gift and would have to be treated as such for tax purposes.
Fannie Mae and Freddie Mac, government-sponsored enterprises that guarantee and purchase mortgages, require the parties to sign an arm's length affidavit for short sales—real estate deals in which the seller owes more on the property than they will receive from the buyer. Fannie Mae and Freddie Mac do that to prevent family members from making a special deal that would allow the seller to later regain ownership from the buyer.
Negotiating an arm's length transaction and the avoidance of a conflict of interest are similar concepts. However, a conflict of interest occurs when the existing relationships of one entity (a person or company) make it difficult or impossible for them to fairly treat or represent two other entities that have different interests.
- In an arm's length transaction, both parties are acting in their own best interest and neither party is giving the other one a deal better or worse than the market would dictate.
- If the parties in a deal have an existing relationship, they should use intermediaries to negotiate and their final price should be in line with the market price determined by an independent appraisal or valuation.
- Transactions that are not at arm's length aren't necessarily illegal, but they may face scrutiny from the IRS or prevent the buyer from obtaining financing.