A 5 lb dog may be appropriate for your co-worker, but with the information you have shared, it is not appropriate for her two sons. Young boys and girls for that matter can play quite roughly with animals and although dogs are quite resilient, Yorkies can also be very delicate at this weight. There just isn't much to them. 5 lbs is very tiny for children to play with. You already know all of this - I'm just supporting you.
So regarding the ethics of the situation, be honest with the breeder but don't offer anything more than the facts you have. She can form her own opinion and I suspect that she already has somewhat or she wouldn't have called you. Leave the decision to the breeder, it's her responsibility to home her babies appropriately.
Good luck with your co-worker.