Definition of Arms Length Transaction
An arms length transaction exists when two independent (unrelated) parties are each attempting to get the best deal possible.
Example of Arms Length Transaction
Assume a company builds single-family residences. An unrelated customer asks the company to inform them of the price for constructing a specific residence. The company prepares a detailed calculation of the final price that the customer will pay. The price will include the cost of all of the materials, labor, overhead, a cushion for the unexpected, and the company's required profit. Assume that the final amount is $240,000. The customer wants the house, but believes there is a little "wiggle room" in the $240,000. The company and the customer go back and forth and finally they agree on a price of $239,000. Since both parties were attempting to get the best price, the transaction is viewed as an arms length transaction. The resulting price should be close to the fair market price.
On the other hand, if the daughter of the company's owner wants the company to build her the same house as the person above, the company may inform the daughter that the house will cost $225,000. Since the customer (the daughter) and the company are related parties, the transaction is not an arms length transaction. As a result, the daughter is able to get the house for less than the fair market price.