Maybe my interpretation is off, but I never considered flanking to be about "where" you strike a foe, but about the fact that they can't watch both of you at the same time. Making an attack against an opponent that can't see you to react is the source of the bonus. This is consistent with the rule for All-Around Vision. This means it's perfectly reasonable to flank a huge creature, in fact it happens in fiction all the time. Also, if the dragon can get a claw on either side of you, you're certainly at a disadvantage, so I can see how larger creatures that can occupy flanking squares around a foe could get the bonus.
The reason those small, "reach 0" creatures can't flank is that they don't threaten a square unless they're in it, so the target doesn't have to watch out for them. This would be fine, except that once you're all in the same square there's no accounting for position. So, once they get close enough to be a threat, the system can no longer account for where they are, and flanking goes out the window.
To correct this problem, I'd try a house rule that says that if you're sharing a square with another creature (aAnd you're both corporeal ...don't really want to go down that rat hole) you need to declare which adjacent square you're closest to, i.e. who's on what side of whom in the square. Then you can use the positioning rules with respect to that creature specifically, like flanking, as though you were in the adjacent square.
