I use my blog in a directory (/blog) and W3 always wants a .htaccess in /blog.
I don't like using one there because I run the site from the main directory and if I include a .htaccess in /blog it actually causes some conflicts with things. I have told it to ignore this and put the re-write rules in my main .htaccess. I cannot tell if the plugin is ACTUALLY working with it like this or if it is simply using basic disk caching then. When I view the source everything shows correctly like it should, so does this mean it is working?
You can check my site at: http://farmvillefanatic.com/