1) Yes, because Win 98SE needs to have its files stored on FAT32, you can't install its boot records on a NTFS partition. Which means if you install 98SE on partition 2, and then XP on partition 1, both have to be FAT32.
Except:
You could make 3 partitions. One FAT32 for boot records (like 50 MB shoudl be more than enough), the Second one NTFS (when you install XP, you can change it to that), and the third FAT32 for 98SE. The procedure is basically the same. Install 98SE, making sure to tell it to install to the third partition. 98SE will automatically install its boot record to the first partition. Then when you've got that all good, pop in the XP disk (inside 98SE) and have it install to the second partition, making sure to change the file structure to NTFS.
Essentially you get:
c: 50 MB boot record partition - FAT32
d: XP - NTFS
e: 98SE - FAT32
However, you will not be able to access the NTFS partition from within 98SE. So if you want to pull files from the XP partition while in 98SE, you will be unable to do so. You can access the 98SE from within XP though.
2) I have never had trouble using any boot disk made in the system (Win 95, 98, or Me) to load an OS. Additionally, I was under the impression that the utilities loaded to the virtual drive were loaded there because they were compressed (zipped) on the floppy and thus couldn't be run directly on the floppy.
But what ever, I guess for some people, you can't use the System Disk created inside windows to reload the OS... Which is one of the reasons you can make one in windows, so that doesn't make sense. But there is no need to argue it. It will either work or it won't, and if you can't find the one made during install, then try the one made in add/remove programs, and if that doesn't work booting from CD should.
3) Yes, XP is savvy towards other flavors of windows, but not necessarily other OS's. If you want to load linux also, there is another process. You shouldn't assume that XP will recognize another non-Windows OS's boot record. And the easiest way to make XP recognize the 98SE installation is to put in the XP disk while in the 98SE installation and start install from there, selecting the other partition as the destination for install.