Photoshop solution:

1. Create the graphic you want to use... preferrably work on a 32 x 32 pixel image
2. Resize it to 16 x 16 pixels
   
3. Change the color mode to indexed
4. Export it using the Gif89a plug-in or photoshop's built in "save for web" and make the background color your knockout color.
5. Save this file as a gif. then close the file
6. Re-open the file, and now, simply "Save As" and choose "windows icon, ico"... VOILA you have a transparent favicon.ico file :)
7. Now follow the instructions mentioned on this site, Mysteries Of The Favicon.ico — How To Create A Favicon In Photoshop