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You are close to correct with choice #3. There is never supposed to be contact between the tip of the rotor and the terminals in the cap. The spark is supposed to jump the gap. Eventually the surfaces become eroded, and the spark has a harder time getting across. That is one of the main reason these parts need replacemnt every so often. (the other is cracks)
There are a couple of O rings that act as distributor seals. A black one about 1 1/4" in diameter, that goes around a protrusion on the base of the distributor, and a small, usually green one that goes on the shaft. I don't know what the 5" one is for. Not familiar with a paper gasket either.
If you have a 90 Turbo, it does not have a Hall effect sensor. Basically, the distributor is empty---nothing in there but the rotor. The computer controls timing and spark advance, getting its information from a crankshaft position sensor. This means that misaligning the distributor is impossible, as it only fits on one way, and the slotted adjusting holes are meaningless. They are simply carried over from the older cars, which did have a Hall effect sensor, and required rotating of the distributor to adjust the timing. Take the distributor off, clean it, install the new O rings, then just put it back on. The rotor tip contact is wide enough that some part of it will align with the terminals in the cap, no matter where in the adjustment range the distributor body is.
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