I have been struggling with this one ever since I moved my WordPress installation from my old Windows 2003 server to a new Windows Server 2008 machine. If I try to use “automatic upgrade” to upgrade to the latest WordPress release or upgrade or add a new plugin I get to the “Connection Information” page asking me to fill out ftp host name, user name and password. When I try to upload a new WordPress theme I get 500 Internal Server Error. I have understood that this is a permissions problem in the file system but have failed to be able to solve it.
I have been trying to give various users and groups permissions on the everything from the entire wordpress directory to the wp-content folder.

However what I did not realize until today is that (at least in my Windows installation) the group IIS_IUSRS does not have any group members but I should instead give the user IUSR permissions. Too easy… 🙂
So simply do this: give user IUSR Modify and Write permissions to your WordPress directory.

Finally!