You Can Lose the Hobby-Loss Case and Still Beat the Penalty

Imagine losing $190,000 worth of deductions to the IRS in a single audit — and still walking away without paying a dime in penalties. That's exactly what happened to a Nebraska veterinarian and his wife in a Tax Court decision handed down this June, and the reason it worked has almost nothing to do with horses.

For nearly two decades, Keith and Rhonda Schumacher ran Schumacher Quarter Horses (SQH), a breeding and training operation on their 50-acre Nebraska property. Keith had been a licensed veterinarian since 1986 and worked more than 60 hours a week at his own practice. Rhonda worked full-time in education. On the side, they bred and showed quarter horses, kept 10 to 25 animals on the property at any given time, farmed 17 acres of alfalfa to feed them, and in 2016 built a $230,000 indoor riding arena.

The problem: SQH lost money every single year from 2010 through 2019, with annual losses ranging from $51,028 to more than $210,000. When the IRS finally audited 2017, 2018, and 2019, it disallowed the losses entirely, arguing the whole operation was a hobby, not a business. The result was $191,179 in back taxes and $33,520 in accuracy-related penalties.

The Tax Court agreed with the IRS on the big question — SQH was a hobby. But it let the Schumachers keep every dollar of the penalty relief. If you run a side business that could get the same "not really a business" label — a horse operation, a boat charter, a photography studio, a farm, a car-restoration hobby that throws off 1099s — this case is worth understanding in detail, because it draws a sharp line between two very different fights: whether your losses are deductible, and whether you get punished for claiming them.

What Section 183 Actually Tests​

The tax code doesn't ban you from deducting losses on an activity you enjoy. It bans you from deducting losses on an activity you don't genuinely intend to run at a profit. Section 183 — the "hobby loss rule" — is the IRS's tool for telling the difference, and it does so through nine non-exclusive factors laid out in Treasury Regulation 1.183-2(b):

1. How you carry on the activity — is it run in a businesslike way, with real records and a business plan?
2. Your expertise, or your advisers' expertise — did you study the field or consult people who know it?
3. Time and effort you put in — is this a serious time commitment, not a weekend hobby?
4. Expectation that assets will appreciate — could the land, herd, or equipment itself gain value?
5. Your success in similar or dissimilar activities — have you built profitable ventures before?
6. History of income or losses — how many years, and how large are the losses relative to revenue?
7. The amount of any occasional profit — even one good year can cut in your favor.
8. Your financial status — do you have substantial income from other sources that these losses conveniently offset?
9. Elements of personal pleasure or recreation — is this something you'd do anyway, purely for enjoyment?

No single factor decides the case, and the IRS doesn't need to win on all nine — it just needs the overall picture to point toward "not a genuine profit motive." In the Schumachers' case, the court found six of the nine factors favored the IRS. The killer facts: 18 straight years of losses (well beyond the 5-to-10-year startup runway courts usually tolerate, even for horse breeding), inadequate books kept only for "tax reporting, and not profit-making, purposes," commingled personal and business bank accounts, substantial outside income (Keith's veterinary practice) that could absorb the losses, and clear personal-pleasure elements in a lifelong horse operation on the family's own land.

There's a statutory safe harbor that flips the burden of proof onto the IRS if you show a profit in 3 of the last 5 years (2 of 7 for horse breeding, training, and racing activities specifically). The Schumachers never got close — which is a useful benchmark if you're running a marginal side activity yourself: if you're several years past startup with no profitable year in sight, assume you're the one who has to prove the profit motive, not the other way around.

The Penalty Is a Separate Fight — and the Schumachers Won It​

Here's the part most people miss: losing the deduction and owing the penalty are two different legal questions, decided under two different standards, and you can lose one while winning the other.

When the IRS disallows a deduction, it typically also tacks on an accuracy-related penalty under Section 6662(a) — 20% of the underpayment attributable to the disallowed item. In the Schumachers' case, that penalty totaled $33,520 across the three years. Section 6664(c), though, carves out a full exception: no penalty applies to any portion of an underpayment where the taxpayer acted with "reasonable cause" and "in good faith."

The leading case on what counts as reasonable cause when you relied on a tax professional is Neonatology Associates v. Commissioner, which set out a three-part test. To win, you have to show:

1. The adviser was a competent professional with sufficient expertise to justify relying on them.
2. You gave the adviser complete and accurate information — you didn't hide or misstate the facts.
3. You actually relied on the adviser's judgment in good faith — not just used them to rubber-stamp a decision you'd already made.

The Schumachers cleared all three. They'd used the same enrolled agent, Robert Cruise, for roughly 20 years. Cruise specifically advised them that SQH satisfied the requirements of Section 183 — meaning he didn't just prepare the return mechanically, he affirmatively told them the horse operation qualified as a business. And the court found that Keith Schumacher "promptly provided all requested information without withholding any facts" when Cruise asked for it. Two decades of continuity, a specific and on-point professional judgment about the exact legal question at issue, and full disclosure — that combination is about as clean a reasonable-cause case as you'll see, and the Tax Court waived the entire $33,520 penalty even while ruling against them on the underlying $191,179 in deductions.

Why This Matters If You Run a Side Business​

Most owners of a marginal or money-losing side activity focus all their energy on the wrong fight. They pour effort into proving the business is "real" — better records, a business plan, maybe incorporating — which is worthwhile, but it's not the only line of defense, and sometimes it's a fight you're going to lose no matter what you do (an 18-year loss streak is a hard fact pattern to spin). The Schumacher case is a reminder that even if the deduction goes down, the penalty doesn't have to go down with it, provided you can document reasonable reliance on a professional.

A few practical takeaways if you're in a similar spot — a farm, a charter boat, a rental property portfolio, a craft business, a consulting practice that hasn't turned a profit in years:

• Get advice on the specific question, not just a return prepared. "My accountant does my taxes every year" is weaker than "I asked my accountant whether this activity qualifies as a business under Section 183, and they told me it did." The Schumachers had the latter, in writing, on the record.
• Use a consistent, qualified preparer over time. Twenty years with the same enrolled agent gave the Schumachers a track record of reliance that a first-year relationship with a new preparer wouldn't have supported nearly as well.
• Disclose everything, including the ugly parts. If you're hiding the loss history, the commingled accounts, or the personal-use element from your preparer, you can't later claim you relied on their judgment in good faith — because they didn't have the full picture.
• Keep the correspondence. An email or engagement letter where your accountant specifically addresses the profit-motive question is far more persuasive at audit (or in court) than your own memory of a conversation.
• Don't confuse penalty relief with deduction relief. Winning the reasonable-cause argument saves you the 20% penalty. It does not get your deduction back. Budget for both possibilities separately when you're deciding how hard to fight an audit.

None of this guarantees you'll keep the deduction — profit motive is still judged on the merits of your specific facts. But it does mean the penalty conversation is worth having on its own terms, with its own evidence, even in a case you expect to lose on the main issue.

Keep the Paper Trail That Makes This Defense Possible​

The Schumachers won their penalty fight because they could point to two decades of consistent professional advice and complete, honest disclosure — which is a lot easier to prove when your financial records are clear, dated, and easy to hand over. Plain-text accounting with Beancount.io keeps every transaction in a version-controlled ledger you can hand to your accountant (or an IRS examiner) with a complete history intact, not a patchwork of handwritten notes and commingled bank statements. Get started for free and build the kind of record-keeping habit that holds up when an audit reaches the years you can't undo.