Max,
I have not had any problems using the color palette with 16 bit images. The conversion policy tells LabVIEW how to convert your image to 8 bits for display, and the palette tells it how to display the 8 bit image. The conversion is all internal, so you don't have to worry about it.
I have attached a quick demo that loads a 16 bit image and displays it using the selected conversion policy and color palette.
Bruce
Bruce Ammons
Ammons Engineering