When a deposited check is returned are there any issues with overdrawing the account or should the check be placed in cash items to collect? Should the check be held by the bank until the account has a positive balance?

Overdraw the account and send a notice to the customer. You have your own midnight deadline for getting notice of dishonored checks back to your customer:

229.33(d) Notification to customer. If the depositary bank receives a returned check or notice of nonpayment, it shall send or give notice to its customer of the facts by midnight of the banking day following the banking day on which it received the returned check or notice, or within a longer reasonable time.

Thanks so much.