I assume that you are talking about compiling B4PPC apps.
The legacy compiler produces code that should work under .NET 1.0 as long as you don't use any libraries that require .NET 2.0. The apps will also run under .NET 2.0 - in fact a little better as .NET 2.0 is more optimised.
The optimising compiler produces code that needs .NET 2.0.
The .NET Framework 3.5 runtime is actually .NET 2.0 with a couple of minor fixes, this may be why B4PPC shows it as vesion 2.0
EDIT :- Damn. Erel's there first again while I was typing