T56 with LS7 clutch?

[Nine Ball]

Now there is a 1/4" spacer between the bell housing and trans case from Mcleod

What is this spacer for? Can you remove it?

What is happening is that your slave cylinder doesn't have enough travel to fully disengage the clutch. That spacer is likely the cause of it. Since you moved the trans 1/4" backwards, that means the slave now has 1/4" less travel into the clutch. Put another 1/4" spacer behind the slave, where it mounts to the trans, and you should be good to go.

Also, be sure you have an adjustable clutch master cylinder, with a threaded rod. That will also help you fine tune the engagement point of the clutch.