I suspect the NEX does,but I would like to confirm.The reason I'm asking is I'm getting an iPod solely for the purpose of using it with my NEX,some ipods apparently sound better than others,but if the NEX handles the DAC duties I would assume it wouldn't matter what iPod I select.

Depends, when connected the NEX converts the signal and all controls go through the NEX.  With blue tooth I believe the phone handles most sound controls, you can use EQ on phone for example.  Obviously, the sound quality is better using the connected experience.

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Sorry,just to be clear,I was referring to a USB connection looking for the best quality sound.

AFAIK the HU does the D/A conversion.