I would note that holding an animal or even potentially illegal activity (like handling a protected species) is not one of iNat’s reasons for something to be flagged as “inappropriate”, see: https://www.inaturalist.org/pages/help#inappropriate
Education via polite comments will probably be more useful in changing behaviors here than flagging.
There’s been previous discussion of handling of observations with potentially illegal activity on the forum including a feature request that’s been closed:
https://forum.inaturalist.org/t/discourage-and-report-illegal-practices/26576
https://forum.inaturalist.org/t/inat-observation-posting-a-possibly-illegally-captive-animal/31797
and there are probably others.
I think one important point is that these observations do have value (see this WWF project about the wildlife trade for instance): https://forum.inaturalist.org/t/wildlife-trade-markets-in-s-e-asia-inaturalist-monitoring/16350
One bit of confusion here might be the popup language for inappropriate which says:
“Misleading or illegal content…” So some users might be giving this flag because they think that something depicted in an observation is illegal. It might be worth clarifying that wording to help in this situation.