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. 5
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. 6
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). 7
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. 8
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. 9
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.