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Whatever the issue was, it's gone. Reinstalled the rebuild kit, took it for a test drive. Brake warning light was on when I first started it but went out with a couple of pumps on the brake. Leak seems to be fixed (the reason I rebuilt the MC in the first place). Brakes are working perfectly. Thrashed it a bit, hard pedal, sure stops, easily lock up those 'big' 255-60s. Happy that it's fixed but not so happy that I don't know what the problem was. Stuck proportioning valve, trapped air, flipped piston lip seal, no idea.
Thanks to everyone that contributed ideas.
I'm thinking that gap is necessary with the lip seal design to allow fluid to get behind the lip.
I do wonder if it's possible that one of those lip seals could 'flip' as the piston is being pushed into the bore on assembly. Doesn't seem likely though.
I agree about the Lip Seal style. I do know that the "O" Ring style will flip itself over and damage itself on the return stroke of the brake pedal. Hence, on the box of a new MC is a bright red label stating: Do Not Force Piston Into Bore, More Than 1 3/8" or you will void the warranty.
That's what I like about the fellow C-3 owners. Everybody seems to have a good sense of humor , willing to give advise ,and not be A**holes with nasty comments.