First off, let's get this out of the way: Dammit, Tedd.
I'm honestly trying to remember what was meant by form levels. I had something very specific in mind when I created this comic, but I forgot what it was later. If I had to guess (AND I DO)...
1st level form - Default form, i.e. not transformed.
2nd level form - A form that is the result of a transformation gun or something similar.
3rd level form - A transformation achieved through shape shifting without an external cause like the TF Gun.
I'm not sure if that's what I had in mind at the time, but it does add up given what William and Gillian are saying.
Sidenote: OH SNAP. URYUOMS CAN SENSE WHEN PEOPLE ARE TRANSFORMED.