Arm's Length Relationship Definition

Generally, the arm’s length relationship definition includes several factors about the parties to the transaction, such as: 

• They don’t have a confidential, familial, or friend relationship
• They are acting of their own free will, not under duress
• They are acting in their own self-interest

These factors demonstrate that the parties to a transaction have equal bargaining power. 

The arm’s length relationship business definition is where parties act independently, negotiate freely, and have no other relationship outside of the transaction. Additionally, both parties must have the same access to information about each other and the transaction itself. The arm’s length relationship meaning is important in contract law because it helps ensure that a transaction is fair. It also helps set the fair market value of the product or service. 

For example, someone selling their home to a stranger might accept a different price than if they were selling the same home to a friend. Most people would be more likely to cut the friend a deal. Thus, the home sale doesn’t reflect its fair market value.

Arm’s Length Relationship Benefits

The benefits of an arm’s length relationship include the fact that the transaction is fair, the value of the property sold is fair market value, and no party is acting under duress or undue influence. Both parties to the transaction can act in their own best interests and negotiate for their own benefit. Another advantage of an arm’s length relationship is that each party has equal bargaining power.

Considerations for Non-Arm’s Length Relationship Transactions

Non-arm’s length relationships have disadvantages that entrepreneurs should consider. A non-arm’s-length relationship is often referred to as an arm-in-arm relationship. In an arm-in-arm relationship, the parties to the transaction have a pre-existing relationship. It could be familial, business-related, or personal. For example, when an entrepreneur transacts business with a friend or family member, they could be more likely to cut them a deal. Unfortunately, many tax laws will still tax them based on the fair market value of the property sold. Anyone considering doing business with a friend or family member would be wise to consult with a tax professional for advice about the transaction.

Other Names for an Arm’s Length Relationship

Another way people refer to an arm’s length relationship is the arm’s length principle. Additionally, the agreement or transaction is called an arm’s length transaction.

Arm’s Length Relationship Examples

What is an arm’s length relationship? Many examples demonstrate the arm’s length relationship definition. One example of an arm’s length relationship transaction is someone selling their home to a stranger. The seller puts it on the market, and an interested buyer makes an offer. Through a realtor, the buyer and seller negotiate a price. Either the parties come to an agreement, or one of the parties walks away. If the parties agree, then the price is likely to closely reflect its fair market value because both parties negotiated with their own best interests in mind and with equal access to information.

Conversely, if someone sells their home to a family member or friend, they’d be more likely to accept less than fair market value because of their relationship.

Summary

An arm’s length relationship refers to a business transaction between parties who are essentially strangers, engaging in a transaction where they negotiate freely and voluntarily in their own self-interests. An arm’s length relationship ensures that the deal reflects the fair market value of the offered product or service. 

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