I've just encountered an annoying error with IIS 7.5 when using virtual directories. Since it took me a while to find a solution I am sharing it here.
I needed to add a virtual directory to an IIS site which allows me to access a bunch of flv files to deliver via progressive download. The virtual directory pointed to a folder outside my webroot and inside the Flash Media Server applications directory.
When I tried to access a file inside this directory via the web browser I ran into an error 500.19 'Cannot read configuration file due to insufficient permissions'.

It took a while and some Google searches until I figured out that the IIS_IUSRS account needed read permission for that folder. To add these I right-clicked the folder in Windows Explorer > Properties > Security > Edit > Add > Advanced > Find Now > Search for IIS_IUSRS > Select > Ok > Ok > Ok > Ok (yes, 4x Ok...).

What a palaver. Why I use IIS? Don't ask, but yes it is a pain to work with at times, as are Windows file permissions. If you want to implement something similar when the virtual directory target is in another Windows domain then you're in for a world of pain.

And one last tip: if you need your IIS site to display detailed error messages then this post by Mike Volodarsk has all the details:
http://mvolo.com/blogs/serverside/archive/2007/07/26/Troubleshoot-IIS7-errors-like-a-pro.aspx