Hi Chris,
1. When a DAC is fed by USB is there some sort of internal conversion to SPDiff inside the machine.
That completely depends on the DAC. E.g. the TwinDAC+ does so indeed, the CrazyT does not. Just two examples from the same house.
Keep in mind that reasons can exist for these disgn decisions, like the TwinDAC+ allowing for both SPDIF and USB connections, and the CrazyT being a "standalone DAC" actually not needing anything than a disk to feed it with data, that not being possible with SPDIF (and added to that a certain type of USB connecting that just does).
2. Whatever is this 12S I keep stumbling across
I2S is an internal protocol for transporting music (PCM) data. "Internal" means : from one IC (like receiver chip) to another (like the DAC itself). It is a most RAW (meaning lossless) connection, a bit similar to SDI connections for video which are found on the better devices (I mention this so you may understand when you know about SDI). I don't think I2S can be an external connection, or maybe a very short one. Anyway, as you can imagine this is not done anyway, because no other devices could connect because it's no "external" standard like SPDIF is. But, suppose you'd have a CDPlayer with I2S output and a DAC with I2S input, it would be the best connection possible.
Oh, and note that different "protocols" can make use of different functionalities. E.g. SPDIF is one way traffic (the receiver e.g. cannot tell "please send again, something went wrong"), whereas USB does have two way traffic. Whether this is utilized by the USB DAC is another matter, but the CrazyT should because it's normally error-corrected reading from disk.
Btw, do not get blind of avoiding the soundcard, thinking that USB is *always* better. I'd rather put it some other way around : since USB DACs are relatively easy to produce, most often you end up with a poorly design, though "cheap" (read : not all the attention was put to it, that could).
Peter