You should check either with your local gas company or with your Town to find out about building codes, and to make sure you are not in violation. You probably need a new water heater. The useful life of these things is 20 years the most. They usually quit very suddenly and leave a big flood. You should consider yourself lucky that yours is "warning" you that it's time to replace it. The new gas heaters and water heaters are much more efficient than the old ones. Your gas bills will be lower. And, because of their higher efficiency, they emit less smoke. Therefore, even if your chimney is too small for your currect system, it may be fine for a new one. But you do need to get impartial assessment from either the gas company and/or your local municipality. Your system may have been approved according to codes that were used when the chimney was build years ago. But it may now be a violation because codes may have been updated. In that case, your system may be okay if there is a "grandfather" provision that avoids forcing all homeowners to update their systems.

Either way,top or side is safe and meets code. There is a slight advantage in have discharge from top. You didn't ask but once the line leaves the t&p valve,it must drain dry. That is to say the line can not run upperward anywhere between valve and final discharge point. I mention it in case existing line from top mounted valve runs directly into wall higher than possible when valve move down and to side. Code requires opening wall to lower connection in that case.

Yes, there is a method to my madness :). I was trying to get as many different people as possible to look at this post. That way, if nobody on Forum A has seen this issue, then maybe someone on Forum B has seen or directly experienced this exact issue and knows the answer. If I had limited myself to Forum A, then I would not get the benefit of Forum B. The same logic applies to suggestions that could possibly solve the problem. The more possible solutions, the better. Of course, I will post the eventual solution to this problem on all forums - the more people that know, the better.

I agree with nigelsgarden that the recirc should work. Did you run a new line back to the hot water heater and feed the recirculated water back into the cold water inlet fitting on the heater? There are easy to install recirc pumps which use the cold water feed to the bath room as the return pipe. The problem here is that with the recirc pump running you won't have any cold water, because the cold water pipe will get packed full of hot water. Mark, if you saw anything discouraging feeding the mini hot tank with the hot water line it would have been to avoid the following situation": 1-You start showering, and the tank gives you nice hot water right away. 2-The nice hot water you use from the tank is replaced by the cold water in the 50 feet of pipe from the hot water heater to the bathroom. 3-As the limited supply of hot water in the mini hot tank starts to become exhausted, the shower will begin to cool down, because the cold purge water is filling the mini hot tank. 4-The shower probably won't go completely cold, because when the pipe purge is done, there will be hot water from the big hot water heater filling the mini hot tank, and the outlet temperature will rise again, until the temp at the shower equals the output form the main hot water heater. If you like to sing in the shower, the cold phase might give your voice a nice operatic vibrato (caused by shivvering) and the arrival of the very hot water can help you with a couple of high notes till you get everything regulated.