Keith Schumacher and Rhonda Schumacher v. Commissioner of Internal Revenue, T.C. Memo. 2026-47 (June 9, 2026)

Keith and Rhonda Schumacher are "longtime hippophiles" who established Schumacher Quarter Horses (SQH) as a sole proprietorship in 2001 with the intention of breeding show horses. Dr. Schumacher is a licensed veterinarian and shareholder in a veterinary practice, Northeast Nebraska Veterinary Services, PC, where he works over 60 hours per week. Mrs. Schumacher is a full-time professional in the field of education. Over the years, the Schumachers devoted significant time to breeding and training their horses, even building a $230,000 indoor riding arena on their property to facilitate year-round riding and training.

Financially, SQH consistently operated at a loss. Between 2010 and 2019, the activity generated net Schedule F farming losses every single year, ranging from $51,028 to over $210,000 annually. During the tax years at issue (2017, 2018, and 2019), SQH reported net farm losses of $161,321, $165,149, and $129,908, respectively. The taxpayers used a separate business checking account for SQH; however, they routinely replenished this account from their personal checking account, effectively using their personal funds as overdraft protection, and frequently paid horse-related expenses directly from their personal accounts.

For approximately twenty years, the Schumachers relied exclusively on an enrolled agent, Robert Cruise, to prepare their tax returns. The taxpayers provided Mr. Cruise with handwritten notes and bank statements rather than maintaining a formal ledger or utilizing business recordkeeping software. Mr. Cruise advised the taxpayers that their activities satisfied the requirements of Internal Revenue Code (I.R.C.) Section 183, despite the activity having never achieved a profitable year since its inception in 2001.

Taxpayers Request for Relief

The Internal Revenue Service (IRS) audited the Schumachers’ 2017, 2018, and 2019 Forms 1040. The Commissioner determined that the Schumachers’ horse breeding and training activities were not engaged in for profit under I.R.C. Section 183 and subsequently disallowed their business expense deductions. This resulted in assessed tax deficiencies of $62,266, $61,466, and $67,447 for the years at issue, respectively. Furthermore, the Commissioner asserted I.R.C. Section 6662(a) accuracy-related penalties of $11,458, $11,697, and $10,365. The taxpayers petitioned the United States Tax Court for relief, requesting a redetermination of the deficiencies and a waiver of the accuracy-related penalties, arguing that they operated SQH with a profit motive and reasonably relied on the advice of their tax professional.

Court Analysis of the Law

The Tax Court first examined the burden of proof, noting that the Commissioner's determinations in a Notice of Deficiency are generally presumed correct, placing the burden on the taxpayer under Tax Court Rule 142(a) (INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); Welch v. Helvering, 290 U.S. 111, 115 (1933)). Since the taxpayers did not argue that they met the requirements to shift the burden under I.R.C. Section 7491(a), the burden of proof remained with them.

Under I.R.C. Sections 162(a) and 212(1), taxpayers may deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business. However, I.R.C. Section 183 restricts deductions for activities not engaged in for profit (commonly known as the hobby loss rules). Because SQH had not produced gross income exceeding deductions in at least two of the last seven consecutive years, the taxpayers could not rely on the Section 183(d) safe harbor presumption for horse-related activities.

To determine whether the activity was engaged in for profit, the Court evaluated the nine non-exclusive factors outlined in Treasury Regulation Section 1.183-2(b): (1) the manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or their advisers; (3) the time and effort expended; (4) the expectation that assets used in the activity may appreciate; (5) the success of the taxpayer in carrying on other activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation were involved. The Court noted that "[t]he Schumachers’ expectation of profit during the years at issue need not have been reasonable, but it must have been a good faith expectation," citing Engdahl v. Commissioner, 72 T.C. 659, 666 (1979).

Regarding the accuracy-related penalties, the Court observed that I.R.C. Section 6662(a) imposes a 20% penalty for a "substantial understatement of income tax". To combat the penalty, a taxpayer must prove reasonable cause and good faith under I.R.C. Section 6664(c)(1). For reliance on a tax professional to establish reasonable cause, the Court applied the three-prong test from Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000): "(1) [t]he adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.".

Application of the Law to the Facts

In applying the nine factors of Treasury Regulation Section 1.183-2(b) to the taxpayers, the Court found that six factors heavily favored the Commissioner. Regarding the manner in which the activity was conducted, the Court emphasized that the taxpayers kept handwritten notes "for tax reporting, and not profit-making, purposes". Relying on Judah v. Commissioner, T.C. Memo. 2015-243, the Court explained that "books and records kept for reducing expenses, increasing profits, and evaluating performance are indicative of a profit motive". Furthermore, the taxpayers commingled their personal and business funds, which the Court deemed "inconsistent with maintaining accurate books and records".

The history of continuous and significant losses also weighed heavily against the taxpayers. The Court pointed out that "SQH consistently incurred losses for at least 18 years". The taxpayers could not prove SQH was still in a startup phase, which, for horse breeding, is typically five to ten years (Engdahl, 72 T.C. at 669),. The taxpayers' substantial income from their primary professions allowed them to absorb the horse activity losses, providing a tax shelter benefit that suggested a lack of profit intent. Furthermore, the taxpayers "derived substantial pleasure from breeding, raising, training, racing, and showing horses," which pointed to recreational motives.

While the taxpayers succeeded in proving they sought out expertise to improve their training capabilities and spent substantial time and effort caring for the horses, this was insufficient to overcome the overwhelming evidence of a lack of a profit motive,,.

However, the Court ruled in the taxpayers' favor concerning the I.R.C. Section 6662 penalties. Applying the Neonatology test, the Court found that the taxpayers "received, and reasonably relied on, professional advice from Mr. Cruise specifically directed at SQH’s compliance with section 183". As an experienced enrolled agent who had handled their taxes for decades, Mr. Cruise met the competency prong. Because Dr. Schumacher promptly provided all requested information without withholding any facts, the Court determined the Schumachers acted with reasonable cause and good faith.

Conclusions

The Tax Court concluded that "the Schumachers did not have an actual and honest objective to operate SQH for a profit during the years at issue". Consequently, the Court sustained the Commissioner’s disallowance of the claimed Schedule F loss deductions for 2017, 2018, and 2019 under I.R.C. Section 183.

However, the Court provided relief to the taxpayers regarding the accuracy-related penalties. Finding that the taxpayers met the reasonable cause exception under I.R.C. Section 6664(c)(1) due to their good faith reliance on their tax preparer, the judge ruled that "the Schumachers should not be saddled with the section 6662(a) accuracy-related penalties". The Court definitively held that they "acted with reasonable cause and good faith and are therefore not liable for the accuracy-related penalties determined for the years at issue".

Prepared with assistance from NotebookLM.