Burl, sorry I wasn't clear and have taken so long to respond...and yes I'm an engineer.
The answer to your question is yes, you can go with a smaller tank, or no tank at all because heating a garage doesn't need a tank, here is why.
Unlike heating water for a shower, say 20 gallons at a time, your garage (when it's cold out) is always losing heat at some rate based on the size, outside to inside temperature differential, and insulation. You need to size your heaters output (BTU) to replenish the amount of loss. Again you can find an online calculator to do this for your building and design inside and outside temperatures, i.e. do you want to be able to heat to 50,60,70 degrees inside when it is 20,10,0 degrees outside.
That being said, most water heaters for domestic hot water do not have enough output to heat a garage. There are two reasons for this. First, simply because heating domestic hot water in general requires much less energy than space heating. Second, because it is an intermitent service. 20-80 gallons in the morning, maybe 30 in the evening and thats it. Well then you have the losses from all of that water sitting there warm all day...Intermitent use actually allows the output of actual heating element to be reduced, or undersized, because energy can be built up all day and night when no loss is happening and stored in the tank. This is evident if you have one too many people take showers on an electric hot water heater. Once you run out of stored hot water, the elements cannot create hot water at the rate its being used.
Basically, the tank makes up for lack of output, but again this only works for intermitent use. Since your garage is not intermitent, you need to size the actual output to match your heat loss. Once you do that, the tank is not necessary.
