The Middle Layer Problem: When Intermediaries Collect Fees Without Delivering Value

HiQuity Solutions
May 10
8 min read

POST 7 of 10

Series - Grant Ready: A Compliance Readiness Framework for Federal Award Recipients

Introduction

Federal awards arrive in September, and before the period of performance begins, some prime recipients will have already set up funding arrangements that auditors will eventually scrutinize and that every party in the chain will struggle to defend.

The structure is familiar: a prime recipient receives a federal award, routes a portion of those funds through an intermediary organization, and the intermediary engages independent professionals to deliver program functions like evaluation, training, or direct client services. The intermediary sits in the middle, collects a management fee, and everyone moves forward assuming the arrangement is compliant because the work gets done.

Whether the work gets done is not the question federal auditors ask, but whether the regulatory obligations created by each layer of that funding chain were met. In most cases of this type, they weren't.

HHS Grantee Note: The regulatory citations throughout this series reflect 2 CFR Part 200, which fully replaced 45 CFR Part 75 as the governing framework for HHS awards effective October 1, 2025. If your organization's compliance policies still reference Part 75, see early posts of this series for what changed and what your organization needs to do.

The Regulatory Framework: Substance Over Form

Under 2 CFR § 200.331, every organization that receives federal funds and passes any portion of them to another entity must make a documented, case-by-case determination about the nature of that relationship. The two classifications are subrecipient and contractor, and the regulation is explicit that the substance of the relationship controls, not the label on the agreement or what either party calls itself.

A subrecipient carries out part of the federal award; it makes programmatic decisions, is measured against whether the program's objectives were met, holds responsibility for compliance with applicable federal requirements, and implements work for a public purpose specified in the authorizing statute.
A contractor provides goods or services that are ancillary to the implementation of the federal program, supporting the organization that is doing the program work rather than doing the program work itself.

That distinction is not a technicality; it determines what procurement processes must be followed before the relationship begins, what documentation must exist throughout the award period, what monitoring obligations the prime carries, and what happens to costs when the classification turns out to be wrong.

There are three scenarios in which this classification gets mishandled, each with its own compliance failure pattern and each with consequences that flow back to the prime.

Scenario One: The Intermediary That Does Not Perform Required Program Functions

The clearest and most common pattern is an intermediary that receives federal dollars, subcontracts all substantive program work to independent professionals, and collects a management fee for facilitating the transaction. The intermediary conducts no evaluation, delivers no training, provides no direct services. Its role is administrative: holding the funds and routing them onward.

The National Endowment for the Humanities, citing 2 CFR § 200.331 and the definitions at 2 CFR § 200.1, states this plainly: an organization that functions solely as a fiscal agent or fiscal sponsor is not eligible for an award or a subaward. A subaward exists for the subrecipient to carry out part of a federal award to contribute to the goals and objectives of the project. An entity that contributes nothing programmatic cannot legitimately occupy a subrecipient position in the funding chain.

When an intermediary of this type is structured as a pass-through entity, the arrangement has a classification problem at its foundation. The prime should have procured those services (the evaluation, the training, the direct work) directly, through a documented competitive process under 2 CFR §§ 200.317–200.320. Instead, it otherwise will have routed funds through a layer that adds no program value.

The management fee compounds the problem: under 2 CFR § 200.403, all costs charged to a federal award must be necessary and reasonable for the performance of the award and allocable to its purpose. A fee paid to an entity that performed no required program function has a significant allocability problem. Federal awards are also cost-reimbursement instruments, wherein recipients and subrecipients may not charge profit above cost. If the intermediary's fee is structured as a markup rather than a reimbursement of documented administrative costs, it may constitute unallowable profit, causing both the fee and the underlying cost structure to become candidates for disallowance.

Scenario Two: The Subrecipient That Becomes a Pass-Through Without Knowing It

The second pattern involves an intermediary that is correctly classified as a subrecipient: it genuinely carries out a portion of the federal award, makes programmatic decisions, and is measured against program objectives. The prime will have structured this correctly. The compliance failure often happens one level down.

The moment a subrecipient engages another entity to perform any portion of its subaward activities, it becomes a pass-through entity itself. Every obligation the prime carries under 2 CFR § 200.332 now flows down to the subrecipient, including the requirement to make a documented subrecipient vs. contractor determination for each lower-tier entity, conduct a pre-award risk assessment, issue a formal subaward agreement with all required federal data elements if the relationship is subrecipient in nature, and monitor performance and expenditures throughout the award period.

Most subrecipients in this position do not know this: they treat their engagements with independent contractors as ordinary business agreements, including a scope of work, an invoice, and a payment. Many will not have written monitoring procedures for the updates, and most will almost certainly have not conducted a risk assessment. Additional obstacles come when if they have not verified SAM.gov eligibility for the contractors they engaged or have not issued subaward documentation with the federal data elements required by § 200.332(b).

When an auditor follows the money through the prime to the subrecipient and then to the independent contractors, every one of those gaps is a finding, and the findings belong to the subrecipient, which means they also belong to the prime, which has its own obligation under § 200.332 to monitor the subrecipient and ensure it is meeting its compliance responsibilities.

The prime cannot delegate its oversight obligations away by issuing a subaward: it remains accountable for what happens beneath it in the funding chain.

Scenario Three: Misclassifying a Required Program Function as an Ancillary Service

The third pattern is the most consequential and also least recognized: occurring when a prime subcontracts a required activity of the grant program like an independent evaluation, a federally mandated training component, or a required direct service to an independent contractor and then treats that relationship as a vendor procurement rather than a subaward.

The distinction between a required program function and an ancillary service is not a matter of organizational preference; it is determined by what the award itself requires. If the Notice of Funding Opportunity or the terms and conditions of the award specify that the recipient must conduct a program evaluation, deliver evidence-based training to a defined population, or provide particular direct services as a condition of funding, those are not ancillary functions; they are the program. The entity performing them is carrying out a required component of the federal award, which is the definition of a subrecipient relationship under § 200.331.

Applying the five subrecipient characteristics from § 200.331 to a required program evaluator makes this concrete, and the evaluator's performance is measured against whether the program's objectives were met. This exercises responsibility for programmatic decision-making regarding evaluation methodology, and adherence to applicable federal program requirements embedded in the award. An evaluator engaged to conduct a federally required evaluation is not providing an ancillary service to the recipient but a required program function that the federal award mandated.

The same analysis applies to training providers, direct service contractors, and any other independent professional engaged to fulfill a specific requirement of the award rather than to support the recipient's organizational operations.

When these relationships are misclassified as contractor procurements, several things go wrong simultaneously: the prime fails to issue a formal subaward with the required federal data elements, fails to conduct a pre-award risk assessment, and fails to establish and execute a monitoring plan. Every one of those gaps is an audit finding regardless of how well the underlying work was performed.

The Thread That Runs Through All Three Scenarios

Each of these patterns produces a different compliance failure, and what they share is a single underlying error: organizations following the money without following the regulatory logic that the money creates.

Federal dollars moving between organizations create legal relationships: relationships defined by what each entity actually does with the funds it receives.

An intermediary that holds funds and routes them onward is a fiscal agent, not a subrecipient.
A subrecipient that engages lower-tier entities to do its subaward work is a pass-through entity with monitoring obligations it may not know it has.
An independent professional performing a required program function is a subrecipient, regardless of whether the agreement looks like a consulting contract.

The prime cannot insulate itself from any of these failures by structuring them carefully on paper, since, under 2 CFR § 200.332, the prime retains full accountability to the federal awarding agency for how every dollar of the award is used and how every entity in the funding chain performs.

Five Questions Every Prime Should Answer Before Funds Move

For each entity receiving federal funds from this award, has the prime made a documented determination under 2 CFR § 200.331 about whether the relationship is subrecipient or contractor in nature based on what the entity actually does, not what the agreement is called?

For any entity performing a required program function like evaluation, training, direct services specified in the award terms, has the prime correctly identified that relationship as a subaward and met all of the documentation and monitoring requirements under § 200.332?

For any intermediary receiving funds that then engages independent contractors to do the work, has the prime assessed whether that intermediary is functioning as a legitimate subrecipient or as a fiscal agent?

And, has the prime evaluated whether the intermediary's management fee is allowable, allocable, and free of unallowable profit?

For any subrecipient that will itself engage lower-tier entities, has the prime ensured that the subrecipient understands its own pass-through entity obligations and has the policies and procedures to meet them?

If the answers to any of these questions are uncertain, the arrangement deserves a compliance review before the first dollar moves.

Use This Tool

👉 📂 Download the HiQuity Subrecipient vs. Contractor Classification Worksheet to support your decision-making before an audit finding can surface.

Is your organization evaluating a grant arrangement that involves multiple layers between the prime and the work being performed? HiQuity Solutions can review the structure before agreements are signed and help you assess the regulatory risk before it becomes an audit finding.

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References

[1] 2 C.F.R. § 200.331. Subrecipient and Contractor Determinations. OMB Uniform Guidance, as revised October 1, 2024. https://www.ecfr.gov/current/title-2/part-200/subpart-D/subject-group-ECFR031321e29ac5bbd/section-200.331

[2] National Endowment for the Humanities. "General Guidance for Pass-Through Entities on Managing Subawards" (March 2023). https://www.neh.gov/general-guidance-pass-through-entities-managing-subawards

[3] 2 C.F.R. § 200.1. Definition of Subaward. OMB Uniform Guidance, as revised October 1, 2024. https://www.ecfr.gov/current/title-2/part-200/200

[4] 2 C.F.R. §§ 200.317–200.320. Procurement Standards. OMB Uniform Guidance, as revised October 1, 2024. https://www.ecfr.gov/current/title-2/part-200/subpart-D

[5] 2 C.F.R. § 200.403. Factors Affecting Allowability of Costs. OMB Uniform Guidance, as revised October 1, 2024. https://www.ecfr.gov/current/title-2/part-200/subpart-E

[6] U.S. Department of Labor. 2 CFR 200 Frequently Asked Questions, Question 38 (January 15, 2025). https://www.dol.gov/sites/dolgov/files/OASAM/legacy/files/20250115-2CFRPart200FAQs.pdf

[7] 2 C.F.R. § 200.332. Requirements for Pass-Through Entities. OMB Uniform Guidance, as revised October 1, 2024. https://www.ecfr.gov/current/title-2/part-200/subpart-D/subject-group-ECFR031321e29ac5bbd/section-200.332