A pine board ceiling even if T&G will offer only a modest sound reduction to the space above and the insulation will not improve it much. The flame spread rating of the wood must be less then 200 but I would not recommend using any kind of combustible material on a basement ceiling.

Our contractor says that even if a wall or ceiling is going to be wood, you should sheetrock first. I'm just passing that along, so not sure what others think.

In our area it's required to have drywall with a tape coat before veneering over with wood or other material types.

"The question is how do I plan the cut-outs for the lights?"

A block on each side of the recessed fixture will give you a nailing surface. The T&G interlocking will take care of the rest.