Alveolar rhabdomyosarcoma (ARMS) is a pediatric sarcoma that typically occurs in older children predominantly arising in the trunk and extremities, and exhibits a worse prognosis than other types of rhabdomyosarcomas. Most ARMS tumors have t(2; 13) or t(1; 13) translocations, involving PAX3–FKHR and PAX7–FKHR fusion genes, respectively. These genetic events result in a molecular gain of function of the fusion protein which is proposed, in a yet unspecified mechanism, to perturb the differentiation of muscle progenitor cells. While a significant amount of work has been done characterizing PAX–FKHR fusion proteins in ARMS and elucidating their involvement in the sarcomagenic process, their relationship to normal skeletal muscle differentiation remains unestablished. In this manuscript we will explore a potential role for mesenchymal stem cells as the cell of origin of ARMS, and the possibility that PAX–FKHR fusion genes may commit these cells to a myogenic lineage while inhibiting terminal differentiation, thus contributing to ARMS formation. We will also review the structure and function of alternate transcripts of PAX3, PAX7, FKHR and the fusion genes PAX3–FKHR and PAX7–FKHR, and discuss the role of these genes and their downstream targets in development of ARMS. Additionally, we will review transgenic mouse models and their ability to mimic the formation of ARMS.