i would think you would cut your template 3" and then add the 1/4" beyond the template line- or you could add your 1/4 seam allowance to your template---most of my templates have the 1/4" seam allowance included -
i don't quite get why you would deduct a whole inch instead of 1/2"???
i use alot of templates- they have never been a whole inch smaller than a rotory cut piece...so i'm missing something i think. your 3 1/2" square is going to finish at 3" so your template would need to be 3" + a 1/4" seam allowance