1) There are three types of reductions, Reduction, % Penetration, and Flat Penetration. They take effect in that order, and only Reduction (Black Cleaver for armor, Starcall's effect for MR, for example) can reduce armor/MR below 0. Penetration (like Sorc Boots or Brutalizer) can only reduce to 0.
2) I assume your main concern with this is Death Lotus. If you drop an improved rally WHILE using Death Lotus, you only get the increased spell damage. If you drop the rally BEFORE using Death Lotus, it double dips (for an attack damage build, not an AP build), giving you increased physical damage AND increased magical damage for Death Lotus.