Keith and Rhonda Schumacher, a Nebraska couple consisting of a veterinarian and a teacher, faced the IRS in Tax Court over nearly $200,000 in disallowed tax losses and over $60,000 annually in deficiencies related to their quarter horse breeding operation, Schumacher Quarter Horses (SQH). The IRS argued that SQH was a hobby, not a for-profit business, leading to the disallowance of losses that the couple had used to offset their substantial income from their primary jobs since 2001. Despite their long-standing dedication to horses, including building a $230,000 indoor riding arena and achieving national championship placements, the Tax Court ultimately sided with the IRS, concluding the activity lacked a profit motive, as it had never turned a profit since its inception and accumulated losses ranging from approximately $51,000 to over $200,000 annually between 2010 and 2019.
The court's decision was based on six out of nine factors favoring the IRS, including that records were kept primarily for tax purposes rather than business management, there was no formal business plan, and the losses were continuous and substantial for nearly two decades. The couple's obvious passion for the activity also contributed to the court's view that it was not primarily for profit. Under Section 183, expenses from activities not engaged in for profit (hobby loss rule) are only deductible up to the income generated by that activity, meaning the Schumachers could not use SQH's losses to shelter their other income.
However, the Schumachers did achieve a partial victory. The IRS had imposed a 20% accuracy-related penalty under Section 6662(a) on the underpayment, which could have significantly increased their financial burden. The couple successfully argued that they had reasonable cause and acted in good faith, as they had relied on their experienced enrolled agent accountant for decades. Their accountant had consistently discussed the Section 183 factors with them and concluded the horse activity was operated for profit, and the Schumachers promptly provided all requested information. The Tax Court agreed, overturning the penalties, citing the couple's lack of tax knowledge and their good-faith reliance on their tax professional's advice. This means while they lost the ability to deduct the losses, they were spared the additional penalty, demonstrating that even when hobby loss deductions are denied, penalties can be avoided if reasonable cause and good faith are shown, often through reliance on a competent tax professional.
