OK, you could partition it into several partitions (e.g. one EXT3 or EXT4 for TC and the remainder as a VFAT), or you just leave it as a single VFAT partition. The latter might not be optimal in terms of performance, but it's the option with the least effort and greatest flexibility (i.e. no commitment of a dedicated space that might turn out to be either too large or too small at a later point in time).
Certainly one point in favour of EXT3 or EXT4 would be the fact that those are journalling file systems. But for a USB pendrive that does not need to be an advantage. The idea has to be to minimise the write activities to the pendrive. TC is optimised in that regard (compared to the usual "scatter installation" done by most Linux distributions), so I think VFAT is an acceptable choice.
If you still need partitioning advice please "sing out". Otherwise the use of 'fdisk' or 'cfdisk' (from the 'cfdisk.tcz' extension) or some GUI partitioning tool like 'gparted' (needs the 'gparted.tcz' extension) and the appropriate formatting command (e.g. 'mkfs.ext3', 'mkfs.ext4' or 'mkfs.vfat' from the 'dosfstools-3.tcz' extension) should be all you need. There should be plenty of other posts in this forum regarding the use of those tools.
After inserting your USB pendrive to your target system you could use
blkid /dev/sd* to get an idea about the device name and the label and / or the UUID of your target file system. As I have written just a few day ago
another post about what is important for USB pendrive setups I recommend you read that post instead of me reapeting most things here again.
In summary, the 'waitusb=...' boot code is mandatory the 'tce=...' boot code is optional. One thing you should be doing is to remove the 'tce' directory from your DOM. As the USB based filesystem of your choice need to have a 'tce' directory anyway I'd suggest you just move it over there. Otherwise (if you want to start from scratch) remove it from the DOM and create a new one on the USB pendrive.
After all those changes to file systems and the boot loader configuration I'd suggest before you start to download and install more extensions that you make sure that TC does the correct 'tce' directory detection. I mean: boot the system and check with
cat /opt/.tce_dir that the intended directory was identified.