OK. Figured it out. Really not that hard.
Within the section that starts
Code:
{if $related_categories}
Change
Code:
<a href="home.php?cat={$related_categories[rc].categoryid}">{$related_categories[rc].category}</a>
to
Code:
<a href="home.php?cat={$related_categories[rc].categoryid}"><img src="{$xcart_web_dir}/image.php?id={$related_categories[rc].categoryid}&type=C" alt="{$related_categories[rc].category|escape}" /><br />{$related_categories[rc].category}</a>
Now, I also got rid of the <ul> and made it a grid format copying section info from the manufacturer_categories template.