How much can executives profit from nonprofits?

As trustees of Hawaii's Bishop Estate, Henry Peters and his four colleagues were the highest paid charity employees in the United States.

Each made roughly $1 million a year, and the estate says their salaries were just compensation for the trustees' work educating Hawaiian children and the complicated job of managing trust assets, such as its vast landholdings and millions of shares in Goldman Sachs.

The Internal Revenue Service, however, doesn't see it that way. Last week, it forced a Hawaii court to remove the trustees from their posts, threatening to revoke the trust's tax-exempt status if the trustees remained. But perhaps more important, the IRS is deciding whether to use a new law aimed at punishing executives who abuse charities for personal gain. If it does, the law - and its first-ever application - could radically change the nonprofit landscape.

"Experts are watching closely to see how the new law is used in the Bishop Estate situation, as that will likely indicate how the IRS will use these new weapons in other, less extreme situations," says Randall Roth, a law professor and trust-law expert at the University of Hawaii.

Passed in 1996 and finalized last August, the Intermediate Sanctions Act allows the IRS to levy personal fines on board members and executives of tax-exempt organizations who receive excessive compensation. Previously, the IRS could penalize leaders of charities only by revoking an organization's tax status, a drastic measure that generally killed the charity and harmed the beneficiaries.

"The Intermediate Sanctions Act was designed to directly penalize wrongdoers when a charity has been misused," says Robert Allen, a Boston attorney who previously headed the Massachusetts attorney general's public charities division.

Until now, charities have largely received light treatment from Uncle Sam. Yet the sheer size of the sector, which employs more than 10 million people and generates more than $500 billion each year, is forcing the IRS to take more notice. "The charitable sector is tremendous," says Mr. Allen. "It fundamentally has organizations that are totally well run and performing heroic work. At the same time, there is enough negligence or misuse of charity to warrant both state enforcement action [and] this stronger federal enforcement."

The new law came after several scandals in the 1990s at nonprofits such as the American Parkinson Disease Association, Adelphi University, and the United Way of America.

Still, its passage has worried some charities. At government hearings in March, charity leaders and lawyers raised numerous objections, claiming that the law's breadth and lack of definition could scare off board members and potential executives.

For their part, the Bishop Estate's trustees have consistently argued that their legal troubles are politically motivated. They say the estate is a unique nonprofit, and the complexity of their job requires much more hands-on management.

What's more, add the trustees, the estate has profited and grown during their tenure. "This board of trustees increased the corpus of the trust by more than $2 billion in a down Hawaii economy," says William McCorriston, an attorney who represents the estate. "And they have spent more on education for Hawaiian children, including dramatic increases in the number of college scholarships."

The estate's only beneficiary is the Kamehameha school, which educates 3,100 students on its Honolulu campus.

SOME legal experts, however, say the Bishop Estate trustees are exactly what the Intermediate Sanctions Act was created for. Former Hawaii State Attorney General Margery Bronster has alleged that the trustees commingled personal money and estate funds in business ventures, raising charges of conflict of interest, and have also hired relatives and friends with lucrative contracts. Two of the trustees are currently under felony theft indictments. And during a two-year legal battle with Ms. Bronster, the trustees spent millions of estate dollars to defend themselves - money that critics say should have been spent on education, not litigation.

Even if it doesn't target the Bishop Estate, the IRS appears to be moving forward with enforcement of its law. An IRS official confirmed that the agency is pursuing a number of cases. "The Internal Revenue Service has made it very clear that they are presently investigating numerous matters around the country under the intermediate sanctions statute," says Allen.