John,
I have two suggestions for you -
1. Replace the two PII systems with more current computers. AMD XP 2.8/512 cache CPU, a motherboard that supports dual channel ram architecture ( Gigabyte 7N400L - built in LAN - for example ), and a 40 Gig. hard drive. 2 - 256 meg PC2700 ram modules ( 512 meg. total ) set up for dual channel use ( see motherboard manual for instructions )A mid tower case with 300 watt power supply, or better, and any other options you need for the computers. XP Pro is best on these systems and for domain logins. You can use the two current PIIs as file storage on a peer to peer and do not use them as work stations. TOOOOO slow.
2. Upgrade the existing PIIs with the hardware mentioned. Should the current case have a 300 watt power supply, or better, you may be able to use the existing case. Should you decide to upgrade and keep Win 98SE, install 384 megs of ram. Win98 will not support anything above 384 megs. of ram.
I would also add more ram to the current XP Pro system. XP LOVES ram.
16 bit apps can be installed on NTFS partitions. The format, FAT16, FAT32 or NTFS, has no effect as to if it is a 16 bit app or a 32 bit app. The application does not care for the OS controls the file system. The OS determines as to what type of apps it can run. I have a client that has a DOS based app installed on a Win 2K server using NTFS partitions without any issues.
I hope this helps you.