Ask anyone being married for the first time why he or she should have a premarital agreement and the answer is commonly: “Why would I, I don’t really own anything?” followed quickly by the romantic sentiment, “and besides, I don’t expect to be divorced.” Unlike certain married individuals, statistics don’t lie. A study published by Harvard University revealed that while most people understood that roughly half of new marriages end in divorce, only 12% of those surveyed thought that they would become divorced.
Young people forget two important financial considerations on their way to the Altar. First, future family obligations might require significant time at home and out of the workplace, leading to greatly diminished earning capacity for the stay at home spouse. Second, under Pennsylvania’s unique marital property laws, any future inheritances and gifts from family members may become unintended windfalls for the recipient’s ex-spouses.
This articles explains why even a young person with few assets should give thought to obtaining a prenuptial agreement. Parents of these folks also need to pay some attention when planning their estates.
- The Neglected Asset
In shrugging off the idea of a prenuptial agreement, most young couples overlook their greatest asset in life. It is, plainly stated as the capacity to earn money. This asset becomes more valuable as a career matures, but will decline in value if one, formerly working spouse, takes significant amount of time off from the workforce. If this asset is not protected, the former young professional who took time off to raise the kids will pay dearly for his (usually her) domestic dedication.
Classically, couples have children and make a huge investment in their education. That education usually pays off in the short run with employment. Most couples who marry are both working and defer parenthood until after their marriage. If things do not work out, they perceive that they will divide the wedding gifts and resume life as it was before marriage. Again, this is not really a problem.
But, add the siren sounds of home ownership and parenthood and the mix starts to change. Again, if both parties have a family and keep working at their full earning capacities they may have financial and custody issues to dispute but they both leave the marriage with the ability to be self-supporting in a meaningful way.
The most common problem arises when the baby is born and it is time to return to work. In many cases both parents are clear that they want one of them to stay at home; perhaps a few months, perhaps until the child is old enough to begin school. The point most often missed is that a parent who steps off the employment escalator for any significant period of time (beyond a few months) is often making a massive sacrifice in terms of his or her earning capacity over the long run. When that parent’s resume is afflicted with the title of “homemaker” employers take a different tack. Young people with graduate degrees and outstanding employment experience that once commanded a six figure salary can easily find that when they return to the market 3-5 years later, the employer is discussing a starting salary that is half what the prospective employee was making when he/she left the market. In domestic law, one of the largest areas of dispute is the conversation between spouses about “returning to work”. It usually ranges from “the other spouse just refused to go back to work” to “ I was encouraged to stay home with the baby.” Memories on this subject are very convenient years after the fact.
About a decade ago we represented a freshly minted M.B.A. student who had met the love of her life in business school. They both had graduated and secured employment at first tier banking houses making six figures a year to start. The prospective husband also had inherited wealth of some magnitude. He wanted the conventional mid-life premarital agreement. “You keeps yours, I keep mine.” Our client came to us and said that seemed fair to her. We counseled her that the scenario was fraught with peril. She was interested in starting a family, albeit not for a couple of years. We cautioned that when she had her child, her future husband could offer her the chance to stay at home without a reduction in lifestyle by resort to his investment income and savings. To our client that seemed like an attractive way to start the parenting years. But, the danger was that once she was out of the employment market for 2-3 years, she could find herself doing the same job for a smaller scale employer and for half what she was making at BigBank. She saw our point but allowed the 12% factor (referred to above) to convince her that hers was the marriage that would always be there. Ten years and two children later, our prophecy proved correct. She was even worse off because she was more than five years out of her field. The premarital agreement we had negotiated did provide for some lump sum payments to her premised upon her leaving the job market to be a parent but even she would concede that she had us negotiate for too little. Where her income potential was roughly half of what it was when she married, her husband had stayed in the market and trebled his earnings while building a resume and accumulating retirement and other assets. After ten years of marriage, she walked out with a $50,000 earning capacity, a small IRA (built before she retired to have kids) and primary custody of two children. Her equally well educated spouse left not only with his inheritance greatly expanded, but a $200,000 retirement account, a $250,000 salary and a career in full bloom. This kind of danger cannot be overstated. Most people who discuss premarital agreements are thinking about the assets they have and toying with the thought of assets they might acquire. But the engine of asset accumulation is income and far too many young people fail to realize that once that engine is silenced, it is very difficult to re-start.
- The Windfall
Future gifts and inheritances raise another host of important questions as well, especially in Pennsylvania. Thanks to this state’s unusual marital property scheme a gift of stock in a family owned business to daughter can become the basis for the unexpected and uncomfortable ex-son-in-laws shared ownership
We live in affluent times. There are many wealthy parents in America who are working with estate attorneys to craft plans that transmit wealth to their children. In making these plans it is often forgotten that a divorce at the recipient end (the child getting the gift) could result in money falling due to the daughter or son in law of the donor. The laws vary from state to state. But that makes it even more complicated because a well orchestrated gifting plan devised in New Jersey or Delaware can be completely undone when the recipient son and his wife move to Pennsylvania.
An illustration can be useful. Mommy and Daddy Warbucks decide to deed their $500,000 home in Dewey Beach Delaware to their daughter. She is married. If the gift is to daughter and son in law together the property is “marital” and subject to distribution in any subsequent divorce involving daughter. But suppose they deed it to daughter only. If she lives in New Jersey or Delaware, her husband has no claim of any nature to the property. But if daughter lives in Pennsylvania, any increase in the value of the home from the date of the gift is deemed “marital” and subject to distribution. So, if the property increases in value by $200,000 and the mortgage is paid down by $50,000 before son in law and daughter separate, son in law has a claim on the $250,000 increase that occurred during marriage. Daughter could find herself in need of $125,000 to buy out an interest her husband never contributed a nickel to create.
The problems become more complicated where family business interests are involved. Typically,
parents will give their children shares of stock in a company business as part of a gifting plan. If the business is becoming more valuable each of those gifts may need to be valued to assay what “increase”
is part of equitable distribution in divorce. If the business or the donee child can’t raise the funds to acquire the “outlaw” interest, the corporation may end up with a former spouses holding shares of family owned stock. That’s not a pretty prospect for any of the participants.
For folks who own businesses of their own, there are other complications. In Pennsylvania, even though you come to the altar with a business of your own, the law is that if the value of the business increases during the marriage, you may be required to share the value of that business with your spouse. Start your own business during the marriage and the law provides that the business is a marital asset subject to division. That ordinarily does not require the actual transmission of shares or partnership interests, but it often does require you to buy out another spouse’s interest even though he or she might not own a single share or have contributed a farthing to creating or growing the business. Thus, if you start a business while married and, at the time you separate or divorce, the business has a value of $100,000 the likelihood is that somewhere or somehow you are going to have to raise $50,000 to “buy out” your spouse’s claim to this asset in equitable distribution. As any person with a new business will tell you, the toughest thing to do is raise cash and the most common cause of business failure is insufficient liquidity. Very few, if any businesses worth $100,000 have $50,000 in working capital or access to loan facilities for any purpose other than working capital.
Premarital agreements or even agreements formed during marriage can address these issues. In so doing, they define what will happen to gifts or assets the parties want to keep segregated. They can also seek to address questions related to loss of earning capacity brought about by the decision of one parent to sacrifice career opportunities to devote energy to child-rearing. The plain fact is that these subjects are better addressed before a marital split occurs and best addressed long before the “I dos” are exchanged. If this holiday brings a pending marriage both the happy couple and their parents should think about whether an agreement now can avoid a war later.