Making a USB Stick or drive bootable may be down to your BIOS primarily - so the first thing you need to check is if your motherboard actually supports this.
Following that, maybe a good starting point is to look at how some of the liveCD distro's are built - Knoppix is an example. You do have the advantage that the boot device is writable, but you have similar space constraints, and you can also tailor it to your hardware.
In theory - USB Drives can be formatted with different partition FS types, although I cannot pretend I knew enough about creating bootable USB Partitions without some good googling, and I seem to recall that you will probably be formatting it with FAT. Cursory attempts turned up the following:
- Boot KNOPPIX from an USB Memory Stick
- Booting Linux off of a USB drive.