I will try to be more clear on each of these questions for you:
Should I set up the master user registration using theUser Registration Solution Pack? 
The User Registration Solution Pack does not utilize sha1 encryption for the passwords, so you would not want to setup the system with this. If you did you would need to update it to make it work with sha1.
Will it work with an existing database and SA1 encryption?
No, it will not work with the sha1, it would need to be updated with SecuriyAssist to do this.
should I just create a new one using Security Assist?
Updating the existing one in PowerStore or URSP would be about the same effort as creating a new setup with SecurityAssist. If you are comfortable with updating your PowerStore with Security Assist then that might be the way to go.
is it possible to adapt the PowerStore3 registration system to work with the existing database and use this for the entire site?
Yes, you can adapt it using SecurityAssist but there is no documentation that is specific to making this update in PowerStore.
will this all work if these directories are in sub directories of my website
There should not be any issue with using this in a subdirectory of your site so long as all of the include paths are retained and the files are uploaded to the proper locations.
