Mancat principal Peter Tavernor is furious that the LSC has clawed back pound;300,000 of additional learning support money, which it felt was wrongly claimed by the college.
Graham Stringer, MP for Manchester Blackley, says that staff were angry that auditors concentrated on lists of names of ethnic- minority students.
In an adjournment debate, he said: "Because of (Mancat's) innovative working arrangements - involving youth workers, and perhaps people who might put a cross down on a piece of paper because they do not have a signature, English not being their first language - there's been a real problem with the audit.
"Public money should be looked after ... but it is now the view of senior management at the college that the audit is being carried out in a racist way. That is not to say that any individual member of the learning and skills council is racist - the process is at fault."
There has already been controversy over Mancat's use of youth workers and unqualified staff. Mr Stringer defended the policy, praising the college for recruiting students from deprived areas who might not have entered post-16 education.
Mr Stringer's suggestion that there may be "institutional racism" within the LSC is now being investigated by Ivan Lewis, the minister responsible for skills and vocational education.
Liz Davis, executive director of Manchester LSC, said: "During the audit, Mancat made general allegations that the funding and audit processes were racist, which the LSC refuted.
"The LSC seeks to promote equality and diversity in the way it carries out all its functions. It provides additional funding for learners from deprived backgrounds. It is embarking on a rolling programme of review to assure itself that it promotes equality and diversity. It has engaged independent consultants to review specific funding policies with regard to operating its additional learner support policy."