It's not so much what you should do, but what IRS should do, is to issue a Revenue Ruling that says this is perfectly acceptable and a good way to encourage voluntary compliance.  That makes too much sense, though, so it seems you are on the right path with your subject line:  File amended 941's, backing out his "wages" and withholding.  It may take a while to get the refunds, which he will need to pay his 1040 taxes.  File an extension and hope the dust settles by October 15.  Have the W-2 and 940 already been filed?  Those should be amended also.  If he is the first client you lose because you didn't catch this soon enough, make sure he's also the last.