President Obama signed into law on Monday a two-year budget deal that Congress approved last week to raise the debt limit and avert a default. To help pay for it, the bill includes a provision that will make it easier for the Internal Revenue Service to audit large partnerships, including hedge funds, private equity firms and even accounting firms.

“It’s a total sea change,” said George Hani, chair of the law firm Miller & Chevalier’s tax practice. “It’s revamping and scrapping an old system and coming up with a new system, which is going to make it easier to audit partnerships. The thought before was that the complexity of the old rules meant certain partnerships were not being audited. Now the ability to make an assessment at the entity level just makes it procedurally easier for the IRS to ultimately get the money which is the result of the audit.”

The new law will change how partnerships are audited by the IRS. “It could be good or bad, depending upon your circumstances,” said Hani. “If you’re one of those partners under audit, perhaps this is easier, perhaps it’s not. But if you were not under audit, now you have a greater chance of being under audit.”

The system that was just scrapped was called TEFRA, named after the Tax Equity and Fiscal Responsibility Act of 1982. A Government Accountability Office report last year looked at why so few large partnerships are audited. It noted that the IRS audited only 0.8 percent of large partnerships (those having $100 million or more in assets and 100 or more direct and indirect partners) in fiscal year 2012 compared to 27.1 percent for large corporations. Of the audits that were done, about two-thirds resulted in no change to the partnership’s reported net income. The remaining one-third resulted in an average audit adjustment to net income of $1.9 million.

The complexity of large partnership structures due to tiering and the large number of partners made it more difficult for the IRS to audit the entities. For example, IRS auditors told the GAO that it can sometimes take months to identify the person who represents the partnership in the audit, as required by TEFRA, reducing the time available to conduct the audit. Complex large partnerships also make it difficult to pass through audit adjustments across tiers to the taxable partners.

“Before TEFRA they had to audit each individual partner, and if you had lots of partners, that was just resource-overwhelming for the IRS,” said Hani. “The bright idea with TEFRA was to say we’ll audit the partnership itself because that’s the legal entity that has the records, that has the information. It’s the one that should be able to justify positions and argue or defend positions, but it still left the adjustments to be made at the partner level. So you’d make an adjustment at the partnership level in the TEFRA audit, and then the payment to the government would only come after those adjustments roll out to the individual partners and the partners pay the additional tax.

“It was that second step that was overly cumbersome, burdensome, and complex and led the IRS, as many would say, to not audit as many partnerships because they would go through all the expense of auditing the partnership, come up with the adjustments, and then the difficulty of actually collecting the revenue was too much for them, so they never bothered going after the partnership in the first place,” Hani explained. “Well, now we’ve addressed that ‘how do we collect the money’ problem by continuing to audit the partnership itself, but now on top of that, saying the partnership is the one that has to pay the tax.”

While that might sound simple and direct from a governance perspective, certain inequities could result. “In any kind of system you have to balance precision with administrability,” said Hani. “They’ve opted for administrability and lose precision, but that’s because the economics of the adjustment generally under the default rules are borne by the current-year partners.”

The new rules take effect in 2018, and they could come as a rude shock to partners who suddenly find themselves under audit for a prior year in which they weren’t even partners in a firm.

“Let’s say you have the 2020 tax year that’s being audited in 2025,” said Hani. “So in 2025 the IRS decides that some additional amount of tax is due. The partners who are partners in 2025 bear the burden of that tax, not the partners who were partners in 2020.”

While the focus has been on the kinds of tax strategies favored by hedge funds and private equity firms, the new rules could affect many other types of partnerships, including CPA firms.

Luckily for smaller partnerships there are provisions allowing them to opt out. “If you have less than 100 partners, you can elect out, but that takes an affirmative act on your part,” said Hani. “I can envision the three brothers who are plumbers and organize themselves as an LLC taxed as a partnership. If they don’t elect out, then their partnership is subject to these rules.”

He pointed out that many partnerships have tax-exempt entities, so the tax impact at the partner level can vary quite a bit. “The basic thrust is that they’ve resolved things that were troublesome for the IRS to make things easier for the IRS, but harder for the taxpayers, to achieve precision,” said Hani.

There is also a mechanism in the new legislation allowing a partnership to issue amended K-1’s to the partners who were the partners in the original year. “People need to be aware of what their rights are, what the rules are, and what they can expect,” said Hani.

An important question for many partnerships will be whether they need to amend their partnership agreement in light of the new law. And there are many related questions that might arise from that one.

“Do they need to have different provisions now when they sell a partnership interest, dealing with this problem of who bears the economic burden of a tax adjustment?” Hani said. “If a partnership is in existence, and a partner sells in 2022 to somebody, and then that person still owns the partnership interest in 2025, should there be an indemnity? Should there be some type of tax agreement? Should there be something to let the partner who’s buying in understand what he or she is getting into? Are they going to need to do more due diligence on what tax exposure there might be from 2020 or 2019 before they sign on and buy a partnership interest? There will be things that people wouldn’t necessarily have thought about before because they always thought the burden for those prior-year taxes were on the prior-year partners. Well, now the burden of prior-year taxes may well be on post-year partners.”

It’s a good idea for partnerships to examine their existing agreements. “At a minimum, they’ve got to go back and look at them, and see if there’s anything there that might cover this,” said Hani. “And if not, do they want to cover it, and should they amend? And then if they sell, what kind of provisions [should there be]? Certainly anyone buying a partnership interest would want to make sure that they address whatever could be essential exposure in the purchase agreement, if not the partnership agreement.”

Expect to see litigation between current and former partners about who got stuck with the tax bill, and whether the possibility of an extra tax bill was properly disclosed or if the extra taxes should be covered under an indemnity. But don’t expect the new legislation to solve the problem for the IRS. There will be more to come, Hani predicts, whether it’s from the IRS or Congress.

“When TEFRA was first enacted, it was applauded as the great thing because it was going to solve what was perceived as the problem of auditing individual partners,” said Hani. “Only over time and as issues developed, and the TEFRA rules were tweaked and modified along the way, did it become this massive complexity. These rules are going to need to be modified and tweaked to address certain things. Let’s just hope they don’t get modified and tweaked so much that they become just as complex as TEFRA.”