They are quite explicitly being paid to coach, not play. It is the coaching programme and the contracts which will be audited and scrutinised, not their playing, which is done in their own time. I can't see your allegation of illegality stacks up here.
When you apply for a grant, you submit a copy of the relevant contract. ie, you must have a signed contract for the application. You don't go fishing for funding and then find someone to fit. Those terms are set by the funders, not the clubs.
And of course clubs look to find synergies between their coaching and playing operations, but this is neither illegal nor immoral. As a volunteer club administrator I would argue it makes bloody good sense.
Why WOULDN'T entities deliver coaching in the community if there was an opportunity and it helped put together the jigsaw at national league level, linking some of our best local players with budding juniors? I would argue that it is often to the betterment of the game to have such links, and if it helps the huge challenge of making the national league work, well and good.
Often clubs try to find work for personnel they feel will add to the fabric of their operations (as do most organisations in the not for profit sector)
My club last year found work for a tractor driver. He was skilled in that area. We were more concerned about how many goals he could score, admittedly, but he seemed to dig good ditches also. It worked well.
If I understand your beef, it is that coaching employment - done under contract and financed through community grants - is somehow more dubious (with a sub-plot of playing ability being more primary than coaching ability).
But I would say if someone can coach and play, terrific. Better to be working within the game than digging ditches, because there are synergies there in attracting the junior population to matches etc (NB some may also think it is immoral to use work links to engender support for a team at the weekends).
Rather than blanket illegality, I would respectfully suggest your concerns are matters for the terms of contract, qualifications etc - and audit of delivery. I certainly can't see that you have established a case for illegality or immorality.
There are avenues open if you have evidence the system is being abused in particular cases.
As someone who has occasionally been at the business end of applying for coaching grants from time to time over the past 10 years, I have noticed a few things.
1. The higher the grant amount, the more scrutiny attached both in terms of application and audit.
2. Quite often conditions are attached to funding. For instance, I found it frustrating when partial funding was awarded - but it was tagged to SPECIFIC coaches within a group application because the funding agency, for whatever subjective reason, was particularly taken with the work being done by, say, a coach with significant name recognition, while the first team coach missed out.
3. I wouldn't wish anyone in football to find themselves the focus of an audit investigation. The process is rigorous, and if you have done something wrong, or lied, I would wager it will be discovered.
4. If there is bad track record of service delivery, future funding is unlikely.
Hope this helps.