Debian installs gutted, the most basic install CD is a couple of hundred meg. You will want to use this, the LiveCD page on the debian wiki above explains how to turn what you create into a LiveCD. You will need a good understanding of the Linux boot process. Personally if I were going to do what you are doing, I would get Knoppix and have a good look at the initrd and /etc/rc which is where all the magic happens when the system boots. Reverse engineering is pretty fun.
Doing a Linux from Scratch is pretty undesirable if you want anything practical out of your system. Another option could be using BSD, as the system is simple to modify. You make any changes you want to /usr/src including even introducing ports to the base system and then 'make build.' FreeBSD already has a LiveCD target. I myself have my own distribution of FreeBSD used internally for servers.
