## Facts

- The Mayers (with a third shareholder) owned all stock of Timber Structures, Inc. and agreed in 1951 to sell it to the Institute, a tax-exempt charity, for $2,500,000 ($10,000 down; balance to be paid over time).
- The deal was structured as a stock sale paired with a leaseback: a new operating company would lease the business, pay 80% of operating profits to the Institute as “rent,” and the Institute would remit 90% of those rentals to the Mayers as the purchase-price stream.
- The anticipated tax results were central: the operating company would deduct rent; the Institute would owe no income tax on rentals due to exemption; the Mayers would treat receipts as capital gains.
- In 1954, the IRS issued Revenue Ruling 54-420 asserting that such rentals would be taxable to the exempt entity as unrelated business income and that payments to the sellers would be ordinary income, not capital gain.
- The IRS advised the parties the ruling would be applied to their transaction after the Mayers had received about $350,000.
- The Mayers had considered a rescission clause for an adverse IRS ruling but were dissuaded by the Institute’s representatives; the agreement ultimately contained no such contingency.
- The Mayers spent years attempting to reverse the IRS position; when unsuccessful, they sued in federal district court seeking rescission and recovery of the business.

## Issues

1. Whether an IRS revenue ruling eliminating the expected tax benefits substantially frustrated the principal purpose of the parties’ sale/leaseback contract, permitting rescission.
2. Whether the later legal development validating similar transactions barred rescission by showing the frustration was temporary or not substantial.
3. Whether general foreseeability of adverse tax action, without express contractual allocation, prevents relief for frustration of purpose.

## Decision

- The Ninth Circuit affirmed the district court’s judgment granting rescission and restoring the property to the Mayers.
- The court held the revenue ruling substantially frustrated the contract’s principal purpose because the bargain was premised on specific tax advantages, not merely an installment sale.
- The court rejected the argument that later legal developments foreclosed rescission; the relevant inquiry was the practical destruction of the contemplated value during the period the ruling controlled.
- The court concluded the risk of the sweeping adverse tax treatment was not clearly allocated to the Mayers by contract, despite awareness of possible IRS scrutiny.

## Legal Principles

- Frustration of purpose may discharge contractual duties and support rescission when a supervening governmental act substantially destroys the contract’s principal purpose while performance remains possible.
- The frustrated purpose must be a basic assumption of the bargain; where tax treatment is the central economic premise of an integrated transaction, its loss can qualify.
- Foreseeability alone does not bar frustration; the question is whether the contract, properly construed, allocated the specific risk to the party seeking relief.
- A subsequent change in law does not necessarily defeat frustration-based rescission if, in practical effect, the contract’s expected value was destroyed for a substantial period and the party did not receive the benefit of the bargain.

## Conclusion

The Ninth Circuit upheld rescission of a tax-driven sale/leaseback after an IRS revenue ruling eliminated the transaction’s assumed tax benefits, concluding the ruling substantially frustrated the contract’s principal purpose and that later validation of similar structures did not undo the prior frustration or shift the risk to the sellers absent clear contractual allocation.


West L.A. Inst. for Cancer Research v. Mayer, 366 F.2d 220 (9th Cir. 1966)