@SMParizo I can't give you legal advice, so you should always consult with your tax expert or business attorney, but the only amount you can legally deduct from tips is the actual fees paid to square on that tip amount.  Square does not have that as an option even if you use square's payroll service.

While you can legally deduct credit card processing from tips collected, being in this business for a long time, I would advise strongly against it.  Let's say you have $1000.00 in credit card tips to distribute in a week.  Let us also assume that represents an average of 10% of gross sales as tips to your employees.  The effective rate with square could be anywhere from say 4.5% to 6.5% depending on if they are online sales, card keyed, or in person transactions and depending on the amount of each transaction.  So let's use your number of 5%.  (Don't forget the only portion you can deduct is the amount that applies to the tip itself, not the transaction as a whole.  So on a 10.00 in person transaction, it costs .39c to process the sale with square.  If 1.00 of that was a tip, you can only deduct 3.9c of the tip and you would have to give the employee .96c of the one dollar.)

So you want to keep the $50.00 it cost you to collect that money on behalf of your employees.  I can appreciate that you want to control costs at any restaurant, but the time it takes you to keep that 50$, keep detailed records, and the principle of it seem counterintuitive to me.

Let me present it like this...If you could pay 50$ to give your employees an extra $1000 dollars a week in compensation with nothing out of your pocket...would you take that deal?  I know I do personally and would do it every chance I get.  This is about taking care of my employees to me and not getting hung up on the cost of doing business.  To me it would be easier to go up .10c on all my items to cover the cost.

I apologize if it seems like I am coming off as lecturing, but I in my seller experience, a business is only as good as the people working there, and I think the cost is worth the investment and competitive advantage.  I want to see everyone succeed.