Hi, I am having a similar issue. I, too, am on a Windows server because the primary domain on our deluxe hosting account was once aspx. That primary domain is now a wordpress site.
I am trying to use pretty permalinks on a domain that is rooted in a subfolder of the primary hosting domain. In other words:
PrimaryDomainRoot <--first wordpress install is here
>SecondaryDomainRoot <--second wordpress install is here
The dilemma appears to be that there is a web.config file in the PrimaryDomainRoot folder... and using pretty permalinks in the secondary domain/wordpress installation adds a second web.config file to the SecondaryDomainRoot folder.
Is there a known way to get around this? Would moving to Linux fix this particular problem? I'm not opposed to doing that, but a third party developed our first wordpress site and it involves a) an older version of wp, b) a custom theme developed by said third party and c) several plugins/widgets. I'm very nervous about moving all of that to a new server.
Thanks for any light you might shed on the subject!