With regard to the second issue, both shafts will rotate - it is 'normal'. There is a lock out arrangement that means you can't engage the thread cutting and the feed at the same time.
Rather than teflon, I would suggest phos bronze or similar to reline the bore rather than teflon. With normal oil flow (I can only assume the lathe was run with low or no oil in the headstock), it will be lubricated. Nothing says you can't cut some grooves in the bore to ensure oil gets in. Teflon (or another bearing plastic) will work, but I would be concerned about rigidity/ movement over time.
Looking at the parts diagram for the head stock, I don't think that scoring will matter too much (although it should be cleaned up). That surface is for the gear to run against when engaging the dog clutch. If you are going to bush the bore of that part, perhaps machine some off the front and make the bush flanged rather than plain.
Michael