Most people who run a side venture know the IRS can be a difficult business partner. It happily takes a cut when the venture makes money. It often refuses to share in the pain when the venture loses money. The hobby loss rules are one of the tools the IRS uses to do this.

So what happens when the IRS audits a long-running activity, decides it is a hobby, and disallows years of losses? The taxpayer owes the back tax. But there is a second question that often matters just as much. Does the taxpayer also owe a penalty on top of the tax?

And can the taxpayer argue that they had a valid business and show records to try to prove it, and contrary to that, in the same case, point out that they should have no penalty as they are not sophisticated in business matters? The two arguments would seem to be at odds with each other.

That second question is where things get interesting. A taxpayer can lose the hobby loss fight and still avoid the penalty. The recent Schumacher v. Commissioner, T.C. Memo. 2026-47, case shows exactly how that happens.

Facts & Procedural History

The taxpayers were a married couple in Nebraska. One spouse was a veterinarian who worked full time at a busy practice. The other worked full time in education. They had been around horses their whole lives.

In 2001 they started a horse breeding operation as a sole proprietorship. They bred and showed quarter horses. They were good at it. Their horses placed at national championship shows on several occasions. They built an indoor riding arena for around $230,000. They put in real time. This was real work several hours a day.

The activity also lost money. A lot of money. It had not turned a profit since it started in 2001. Between 2010 and 2019 alone the losses ran from about $51,000 to over $200,000 a year. The couple reported those losses on their tax returns and used them to offset their substantial income from their day jobs.

The IRS audited the 2017 through 2019 tax years. It said the horse activity was not engaged in for profit. It disallowed the loss deductions and determined deficiencies of more than $60,000 a year. It also tacked on accuracy-related penalties under Section 6662(a). The couple petitioned the U.S. Tax Court to contest the determination.

What Makes an Activity a Business and Not a Hobby?

The starting point is Section 162. It allows a deduction for the ordinary and necessary expenses of carrying on a trade or business. If the horse activity is a business, the losses are deductible against other income. That is the whole ballgame.

Section 183 is the limit. It says that expenses from an activity “not engaged in for profit” are deductible only up to the income that activity produces. This is the hobby loss rule. If your activity is a hobby, you cannot use its losses to shelter your salary or your other business income.

This is not a new provision. The hobby loss rules have been around for decades, and the IRS audits them often and we have covered them at length on this site. The question is always the same. Did the taxpayer have an “actual and honest” objective of making a profit? The profit expectation does not have to be reasonable. But it does have to be genuine.

The Nine Factors

There is no bright-line test for profit motive. The regulations list nine hobby loss factors the courts weigh. They look at how the activity is run, the taxpayer’s expertise, the time and effort put in, whether the assets might appreciate, the taxpayer’s track record in other ventures, the history of income or losses, any occasional profits, the taxpayer’s other income, and whether personal pleasure is involved.

No single factor decides the case. The court adds them up and looks at the overall picture. For horse activities there is also a safe harbor. If the activity shows a profit in two of seven consecutive years, it is presumed to be for profit. The horse operation here never had a single profitable year, so the safe harbor did not help.

You can start to see the problem here. The couple were clearly skilled and clearly devoted. But skill and devotion are not the same as a profit motive. The court found that six of the nine factors favored the IRS. The records were kept for tax purposes rather than to manage the business. There was no business plan. The losses were continuous and large for nearly twenty years. And the couple plainly loved the activity. So the court held that the horse operation was not engaged in for profit, and it sustained the disallowance of the losses.

Losing the Activity But Beating the Penalty

That should have been a bad day for the taxpayers. They lost years of deductions and owed real money. But with that said, it is often a timing issue. If the IRS determined that the activity was not a business, there is still some possibility that the expenses may be deductible in a later year. This is often true for inventory costs, capital expenditures, research and development costs, organizational costs, and true startup expenditures incurred before business operations began.

Setting that aside, the IRS also wanted a 20% accuracy-related penalty on the underpayment. This is worth pausing on. A hobby loss case is not just about the tax. The penalty can add another fifth on top of the bill. For many taxpayers, the penalty is the part that hurts the most.

The penalty is not automatic. Section 6664(c) provides that no accuracy-related penalty applies to any part of an underpayment if the taxpayer shows reasonable cause and that they acted in good faith. One of the most common ways to show reasonable cause is reliance on a tax professional. The taxpayer has to show three things. The adviser was competent and had enough expertise to justify reliance. The taxpayer gave the adviser the necessary and accurate information. And the taxpayer actually relied on the adviser’s judgment in good faith.

The couple cleared all three. Their accountant was an experienced enrolled agent who had handled their returns and bookkeeping for decades. He did not just plug in numbers. Each year he discussed the Section 183 factors with them and concluded the horse activity was operated for profit. The veterinarian promptly answered the accountant’s requests for information and there was no sign anything was hidden. The couple themselves had little tax knowledge — one fixes animals and the other teaches children. So naturally, there is an argument that they were entitled to lean on their accountant’s read of a genuinely murky area of the law.

The court agreed. It held that the couple had reasonable cause and had acted in good faith. The penalties were thrown out, even though the underlying deductions were not. They lost the activity and kept their penalty money.

Why the Same Facts Cut Both Ways

There is something worth noticing about this result. The same lack of formality that sank the profit motive argument did not sink the penalty defense. The couple had no business plan and sloppy records, which helped prove they were not running a business. Yet they still escaped the penalty.

Why? Because the penalty question is not about whether the taxpayer was right. It is about whether the taxpayer was reasonable. A taxpayer can be wrong on the law and still be reasonable for relying on a qualified adviser who looked at the same facts and reached a defensible conclusion. The profit motive test asks what the taxpayer was actually doing. The reasonable cause test asks whether the taxpayer made an honest and reasonable effort to get it right. Those are different questions, and they can have different answers.

It helps that the accountant here did not just sign the return. He affirmatively considered the Section 183 factors every year and gave the couple a conclusion. That is the kind of advice a taxpayer can point to later. Compare that to a preparer who simply takes whatever numbers the client hands over. The taxpayer who can show their adviser actually weighed the issue is in a much stronger spot on penalties.

The Takeaway

Hobby loss audits are common, and they are hard to win when an activity loses money year after year and the taxpayer plainly enjoys it. But the tax and the penalty are two separate fights. Even when the deductions are gone, a taxpayer who relied in good faith on a competent adviser who actually looked at the profit motive question can avoid the accuracy-related penalty. The lesson from this case is to use a qualified tax professional and to make sure they put real thought into the close calls. Document that they considered the issue. If the IRS later disagrees, that record can be the difference between owing the tax and owing the tax plus a penalty.

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