Drosophila Mad proteins are intracellular signal transducers of decapentaplegic (dpp), the Drosophila transforming growth factor beta (TGF-beta)/bone morphogenic protein (BMP) homolog. Studies in which the mammalian Smad homologs were transiently overexpressed in cultured cells have implicated Smad2 in TGF-beta signaling, but the physiological relevance of the Smad3 protein in signaling by TGF-beta receptors has not been established. Here we stably expressed Smad proteins at controlled levels in epithelial cells using a novel approach that combines highly efficient retroviral gene transfer and quantitative cell sorting. We show that upon TGF-beta treatment Smad3 becomes rapidly phosphorylated at the SSVS motif at its very C terminus. Either attachment of an epitope tag to the C terminus or replacement of these three serine residues with alanine abolishes TGF-beta-induced Smad3 phosphorylation; these proteins act in a dominant-negative fashion to block the antiproliferative effect of TGF-beta in mink lung epithelial cells. A Smad3 protein in which the three C-terminal serines have been replaced by aspartic acids is also a dominant inhibitor of TGF-beta signaling, but can activate plasminogen activator inhibitor 1 (PAI-1) transcription in a ligand-independent fashion when its nuclear localization is forced by transient overexpression. Phosphorylation of the three C-terminal serine residues of Smad3 by an activated TGF-beta receptor complex is an essential step in signal transduction by TGF-beta for both inhibition of cell proliferation and activation of the PAI-1 promoter.