RE: On the second option you have the ability to add categories. Is this something that if a user is managing there directory listing they can actually select the categories that they want to add/remove to/from their listing.
Ok, I was thinking something different when you asked about editing categories. I was thinking actually editing the category. The Form addon does allow which categories are attached to a submission. It does not add new ones. It is a list of the categories already added.
If you want user to be able to add and maintain their own entry, install and configure the Link addon. If you want to allow the user to do this from the frontend instead of their admin profile page, install and configure the Form addon. Just do not enable the “Submit New Entry” option as mentioned in the Form docs.
Hope this helps!