You can use forced perspective even with overlapping elements in various ways. For the problem of puppets in front of puppeteers, there are two methods in reach, both usually involving something that obscures the large character wherever the small one crosses in front. For example, the puppet is in a box, and we see the puppeteer behind, looking over the lid of the box above. Or, the puppeteer is looking through a window over the puppet, or crossing from a doorway behind the puppet. The first method is to stick a mirror in front of the camera, with its edge corresponding to the division between large and small. (As the edge might be in fuzzy focus, align it where it isn't noticeable, like the center of a beam with sharp edges matching on both the full size and miniature sides.) Have your large character perform in the mirror, where they may appear to cut off behind the small character. The second method is to conceal the puppeteer's body another way, such as having them lie/sit on a shelf that is disguised as a window so that it seems as if their body continues behind the puppets (or even align it with an enlarged pair of legs behind the puppets). Note how Darby O'Gill appears to be further away than the leprechaun by standing behind a piece of shelf in the set that matches the floor on which the leprechaun stands: http://2.bp.blogspot.com/_BbhzGWD_EOQ/S2vttylhY5I/AAAAAAAAK94/7rH9j4i9Po...(6).jpg ... Examples of actors appearing to look through windows that are apparently hanging above the "puppet" performer (I'm guessing they're reclining on shelves while appearing to stand normally behind the walls) occur more than once in "The Golden Key," a Russian version of Pinocchio from 1935 that you can find on YouTube. The puppet was often a stop-motion figure, but when combined with actors, was usually an actor in a costume shrunken via forced-perspective tricks very similar to Darby O'Gill. They usually did an excellent job with the illusion.
Agreed that the illusion doesn't work here, but it's great to help illustrate the complexity of perspective illusions. If you focus on the table, you see that they achieved that specific illusion perfectly, while learning pretty fast how that wasn't nearly as important as designing the effect around the orientation of the actors. Sometimes a mistake is more helpful to learn from than a perfect example. I noticed that even in LOTR there were a couple of moments with Gandalf and one of the Hobbits (can't remember if it was Frodo or Bilbo, sorry) where the cross-table lineup still looked like one actor was merely sitting closer to us than the other, despite the fancy moving rig that kept the table aligned. Possibly, the table crowded with dishes (maybe to hide the table split?) worked against the LOTR makers in that example due to the lack of cues to connect the small table to the big table. If, in the example posted here, the raised table were split vertically from the lower table as ponysmasher suggested while a visually cue aligned the actors horizontally, it would work. I think making sure their elbows were aligned straight across would sell the whole thing.