This question should help you out:
Creating a new website on IIS: Application vs. Virtual Directory. Whats the difference?
"There are a few differences, here are
the biggest:
In IIS 6 and up, you can assign a Web Application a certain "protection"
level. (e.g. protection levels,
application pools, etc). You can't do
this with Virtual Directories. If you
are working with ASP.NET, the search
for the master "Web.config" file for
your application stops at your
application level. For a working
directory it will actually check your
parent hierarchy for settings as well.
These are the two biggest differences
in my opinion, although there are
other small ones as well."
- mjmarsh