I wouldn't bother turning 2-channel Dolby Surround into 5.1 with either software or hardware; any surround sound system will have hardware decoding for DPL from 2-channel sources. Let the viewer decide whether to turn on surround decoding or watch it in stereo.

ALAC, FLAC, WavPack and The True Audio are some lossless formats that are legal in mkv. (No, I've never come across TTA either.) Of those, FLAC seems like it would be the best-supported.

As for converting AC3 to lossless, I can't see how that is any different from just playing the AC3 file in the first place. Personally, I was always disappointed in the audio from DVDs; it just didn't seem as "alive" as laserdisc PCM. No, I haven't blind tested this, but Widescreen Review's DVD/LD comparisons often said the LD sound was better.