The letter from the IRS is incorrect. You'll need to dispute that with the IRS. This represents income to the beneficiary (you, I assume) that was required to appear on Form 1040 line 5a. However, it is nontaxable because the amount in box 5 equals the amount in box 1, so it's proper that it was excluded from line 5b.
The payer should have put a zero in box 2a because it is apparent that the taxable amount is zero. Some payers mistakenly believe that a blank entry in box 2a is the same as a zero entry if box 2b Taxable amount not determined is unmarked, but that is not precisely following the instructions for Form 1099-R. A strict reading of the instructions indicates that a blank box 2a means that the payer does not know the taxable amount and, if that is the case, would necessitate also marking box 2b Taxable amount not determined. It's possible that the IRS examiner got confused by the blank box 2a and overlooked the amount in box 5 and the fact that box 2b Taxable amount not determined was not marked.
