Proving ALLTM complement not recognizable
First, there is a small typo in (1) - if $\alpha$ is not a legal encoding, then you should return something that is in $ALL_{TM}$ (since you are reducing to the complement).

For your question: the key point here is that a TM does not always halt on its input. Thus, the phrase "otherwise accept" in your suggestion for (2) is not computable. If you run $M$ on $\epsilon$, and $M$ does not halt, then the lanugage of $M'$ will be $\emptyset$, which makes the reduction fail.

In general, when you perform reductions that output a machine that simulates another machine, you must always consider the possibility that the latter will not halt. If this poses a problem (as it does here), a good trick to circumvent it is to limit the step number, and since often you want this limit to exist, but to be ``unbounded'', then using the input for the machine as a limit is a good idea.