Let me explain what means all the Generation 1 prompt
VC: Pokemon legal for VC games, that means only pokemon that could be obtained in the Virtual Console release are legal, that exclude any pokemon from generation 2 (until VC2 release) but also events from the GB Era and Pokemon Stadium gifts
Phisycal Cart No Gen 2: Is just like VC but allowing Pokemon Stadium gifts. This means only pokemon possible in generation 1 games without using generation 2 games are legal.
Phisycal Cart with Gen 2: This option is the most complete one, allowing all generation 1 and 2 games and Pokemon Stadium 1 and 2.
About Generation 2
The common mistake is to think the only thing included allowing gen 2 games are gen 2 movesets. No, there are more changes that could make a pokemon legal if gen 2 is allowed but illegal without gen 2, even without using gen 2 moves.
First, keep in mind there are pokemon that can be obtained at a lower levels in gen 2. For example, a level 5 vulpix is not legal in generation 1 without using gen 2 games.
Second, and this is what make illegal most of the hacked pokemon the people try to make for gen 1, is the catch rate. The catch rate is stored on the pokemon and the same data is used by generation 2 to store the held item. But in game is not possible to change the stored catch rate/held item in a gen 1 game, that means a gen 1 pokemon that has not been traded to generation 2 should have the exactly catch rate from its encounter.
For example a Buterfree should have Metapor or Caterpie catch rate. If the catch rate is 0 or matches another generation 2 held item is illegal if generation 2 tradeback is not allowed in the legal analysis.
Third, in game trades. Just like the first point, generation 2 allow legal pokemon at lower levels, and that make legal some trades with lower levels using generation 2 pokemon.
Also about Mew events, the VC Event should be legal on VC saves only, and GB events legal in GB Carts, but GB Era Events are not yet implemented in PKHex.