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This question is related to SharePoint 2010.

It seems that the only way to allow users to set item permissions for items in lists/libraries is to grant them "Manage Permissions" on the Site Level. Thereby giving them carte blanche to do whatever they'd like to the entire site. Is this true? I'd like to allow users to configure who can/can't access list/library items they add without giving them a free for all.

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You can in fact give the 'Manage Permissions' Permission level only to a specific list or even a smaller item and the users with just manage permissions will be able to view and edit the permissions for the item in question.

The only way they will have it on the site level is if you grant it to them on site level. Naturally you have to break inheritance on the specific item you are granting them that permission on however.

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