Oh I'm an idiot! I messed up bad! I mixed my 1080p and 720p files by accident and had 720p files in the 1080p folder (hence the 1080 to 720p thing with Lord of the Rings.) iTunes WILL NOT CONVERT the files and neither will Apple TV. Even though there was a thread somewhere on Mac Rumors saying they could, I just tested with a definite 1080p file and it will not.
I have both 1080p and 720p in my iTunes since I sync movies to my iPad so the ATV2 has been playing my 720ps since those are the ones with album art. Sorry for the confusion

Now I have to re-rip about 10 blu-rays that I only ripped at 1080p

I would have never of caught this if I didn't go test just now

That would have been embarrassing when friends come over and I wanted to watch one of the 1080p movies
Ok, the 720p files were the ones playing on the ATV the whole time and they play just fine with my setup and my encode settings. In the settings I listed a few responses back, just substitute the "original" size to "720p" and everything else is still the exact same.
As for the AC3 5.1 channel it does have the option under the Audio tab for that channel and you can use AAC if you go under the options. I'm not too good with audio settings so I'm not totally sure what all this means but I do see options to change to them.