When it comes to SEO in general, when should I use subdomains vs subdirectories (subfolders)?

The subdomains vs subdirectories debate is a bit strange because many people seem to think either one approach or the other should be implemented, when really they are two different animals all together and a combination of using both is appropriate in many situations with respect to search marketing.

The decision to utilize subdirectories and or subdomains can be thought of as a marketing and an information architecture consideration, largely based on how you want your site's content to be recognized by the engines and how you want to position yourself on the web for maximum profitability. 

You could think of it like this: a sub directory is like a label to help describe the meaning of a page or group of pages on a website while subdomains are actually separate sites in themselves.  For example, you could build up your existing website using subdirectories or you could create a totally new site using a subdomain.

When to use subdirectories

Let me first be clear that subdirectories from a search engine's point of view are simply a cosmetic feature that help make a URL look more structured and logical.  Some webmasters will physically create sub directories on their file system to organize pages while other sites, for example sites built in drupal, serve up a URL path containing forward slashes to represent a subdirectory architecture in order to give the appearance of organized content on the server (with that said, you really don't always need to use subdirectories if you wanted to have all pages on your site sitting in the web root).  And so, the benefits of subdirectories are...

• Organization - Subdirectories are great for organizing content into meaningful, descriptive URLs.  If you're looking to grow your site and categorize content in a meaninful, logical way then subdirectories are a good way to make your URL path's more search friendly.
• For relatively smaller sites, keeping your content in one place will help your site to build initial authority vs spreading too thin with sub domains.  Keep in mind that having content spread out across multiple sub domains won't help with any one site's authority/trust.
• Building dominance in one place over time - The more authority and trust a site builds with the search engines the easier it becomes to rank new content for related keyword terms that would have taken you much longer had you started from scratch. New content can be organized by subfolders.
• Easier to manage - Using sub directories can be easier to manage than sub domains for the less technically savvy.
• Basic geo targeting - UPDATE 3-11-10, google webmaster tools now lets us set geo-location preferences to sub directories.  The idea is to create a new "site" listing in google webmaster central that also includes the subdirectory, so in addition having a www.domain.com listing you would create an additional listing for www.domain.com/fr (France) or www.domain.com/uk (for the UK) and then set the geo location accordingly.  Note that you can't assign an IP to a sub directory, and IP's are generally signals of geo location, so sub domains would likely be a stronger candidate for pure geo targeting.

When subdomains are more appropriate

Remember that Google considers sub domains separate from their parent domains:  sub.yoursite.com is considered a different site altogether compared to yoursite.com when it comes to search engine authority.  A good rule of thumb is to market content using subdomains when each subdomain needs to be positioned as an expert on the topic at hand, so long as that content is semantically different.

• Different content - If you have a site with many specific themes, topics or products that aren't well related then using sub domains would be a better way to help partition chunks of the site into more categorical sections that search engines can promote.  Remember, being a jack of all trades won't help you compete against the expert who dedicates their energy in one area of focus. For example, Google has their news product (news.google.com) and maps product (maps.google.com), and because they're fundamentally different from each other and different than Google's main search product, they aren't mixed together on the same domain.
• Be competitive in many, related areas - If you have the money and resources, then you can promote related themes that self re-enforce each other, say via the site navigation.  Consider seobook.com, Aaron Wall wrote a book on SEO (seobook.com).  Then take a look at tools.seobook.com: he's targeting "SEO Tools", training.seobook.com targets "SEO Training" and so on.  Do a search for "SEO" on wordtracker or keyword discovery's free search tools and you will see each vertical (seo tools, seo training) is a popular topic among searchers.  There are several themes Wall is targeting and all themes are connected from the main site's navigation, making it easy for visitors to be exposed to the sub domains - and so each theme/sub-vertical is exposed to the user through the site's navigation.  Wall has spent a significant amount of time building each sub vertical because he knows that as his main site's authority grows for the brand of "seo book" related searches it begins to drown out his main site's ability to rank for broader "tools" and "training" related queries, so he built sub domains to become authoritative for just those themes.
• Multiple listings - It's possible, though not always to reap more than the two listing limit for a given query using sub domains in Google.  Subdomains can be a good way to snag more brand based searches.
• Target different regional markets more effectively.  Sub domains are easier to market to specific geographical regions: you can assign an IP address to a sub domain and even set a geographical preference in Google's webmaster tools for each sub domain (sub directories can have their geo-preference set but can't be assigned an IP in another country, which might also be a signal of geo location).
• Branching out using existing brand strength.  If you already have a well established domain and want to expand out into other areas not completely related to your main site's topics then a sub domain might be a good option.  At the same time, people associate the sub domain with your main domain's brand, which means it can be easy to build up momentum on a vertical related to your main site.
• What are your business goal? If you plan on growing and then selling portions of your site in the future then using sub domains would make it easier to section off pieces for others to acquire/purchase.

It's a perfectly good idea to organize content using subdirectories on each of your subdomains as well, so using subdomains and subdirectories do actually go hand in hand.

If you've just skimmed this article

If you're just skimming this article and want my executive summary, I'm saying subdirectories and subdomains can each be used to market web content differently, subdirectories describe what individual pages are about and subdomains describe what individual sites are about (Google treats subdomains as separate sites while subdirectories are just part of the same site).  You can also say that subdirectories are a more granular way of marketing content via a search engine while subdomains are a more general method.  Either way, search marketers can and should be using both, not arguing if one is simply better than the other.