You can call that a red flag, but it is the reality I live in. Maybe most of your candidates don't have that problem, but I would definitely be eliminated.
But since almost everything we do is in some way technically illegal, it is important for everyone to be able to function under that premise.
I mean, just to cut the check technically the employer would need a W-9, a work for hire contract, and who knows what else. Let's call the lawyer and spend $5k deciding whether we can do this, and then decide 6 months later it's too risky.... Or, we do it, get better hires, execute on our plans better, meet revenue targets, and succeed in the market, by not following all the rules, just the rules that matter.
Knowing the rules to follow and the rules to forget is the hardest part, but a crucial skill in life and business. The more you push the envelope, the faster you can run, and the more likely you are to combust. See Zenefits...
Learning of your little deal to pay them for software development work will be the stick they use to hit you with that interference suit.
"Work for contract for other employers" could literally mean I can't help my neighbor mow his lawn in exchange for a beer. In this case what it really means is a non-trivial amount of work done for meaningful profit.
If I fix a friends computer in exchange for a nice meal, I am using my relevant skills to perform work, but I'm not actually violating a contract forbidding outside work in a way that could ever possibly result in damages or firing for cause.
For a potential employee to be so rule-stricken as to concern themselves with performing a coding interview, that would be the potential red flag for me. So this could actually be another positive outcome of this approach.