Yah, paint.net is a good one, or if you wanna cheat then you can make the file and save it as a jpg, (provided its 512x512 or bigger) in your data/skins folder so its named like its a skin file(xf_mycar.jpg for example) and LFS will convert it to a dds itself, then just find it in your data/skins_dds folder and move it into the data/dds folder.
Since the CS5 is 'out', without being 'online', it's quite hard to find a working link for the trial version of CS4. I found one and I'll search again but I can't garantuee you I'll find one.
All i can think of is that you have somehow downloaded an older crpapy version that cant handle dds files, so heres the most current version download for paint.net