Alveolar rhabdomyosarcomas (ARMS) are highly malignant soft-tissue sarcomas that arise in children, adolescents, and young adults. Although formation and expression of the PAX-FKHR fusion genes is thought to be the initiating event in this cancer, the role of PAX-FKHR in the neoplastic process remains largely unknown in a progenitor cell that is undefined. We hypothesize that PAX-FKHR determine the ARMS progenitor to the skeletal muscle lineage, which when coupled to the inactivation and/or activation of critical cell signaling pathways leads to the formation of ARMS. Because a number of studies have proposed that mesenchymal stem cells (MSC) are the progenitor for several of the sarcomas, we tested this hypothesis in MSCs. We show that PAX-FKHR induce skeletal myogenesis in MSCs by transactivating MyoD and myogenin. Despite exhibiting enhanced growth in vitro, the PAX-FKHR–expressing populations do not form colonies in soft agar or tumors in mice. Expression of dominant-negative p53, or the SV40 early region, elicits tumor formation in some of the PAX-FKHR–expressing populations. Additional activation of the Ras signaling pathway leads to highly malignant tumor formation for all of the populations. The PAX-FKHR–expressing tumors were shown to have histologic, immunohistochemical, and gene expression profiles similar to human ARMS. Our results show the critical role played by PAX-FKHR in determining the molecular, myogenic, and histologic phenotype of ARMS. More importantly, we identify MSCs as a progenitor that can give rise to ARMS. [Cancer Res 2008;68(16):6587–97]