The overall length is measured with the stock extended. Therefore, it is ok if the overall length drops below 26" with the stock folded.
Regarding broken equipment, there isn't anything wrong with having a rifle with a broken stock. ATF isn't going to kick your door down. Just get it fixed as soon as possible and don't worry about it. Parts break all of the time. Semi autos go full auto with broken parts. ATF doesn't raid you that night. Just fix it. If your buddy is really paranoid about it, just break the gun down.